David Wolf, an adviser to Bank of Canada’s governer, Mark Carney, spoke in Edmonton today about Canada’s housing market.  I found some of his comments peculiar to say the least.  Here are some excerpts from his speech:

“In the Bank of Canada’s view, it is premature to talk about a bubble in Canadian housing markets. Recent house price increases do not appear to be out of line with the underlying supply/demand fundamentals.”

Supply & demand definitely do play a part in establishing house prices.  However, that is only a portion of the fundamentals that need to be looked at.

“It’s absolutely not debatable that housing prices cannot rise faster than incomes over the long term,” said Will Strange, professor of real estate and urban economics at the Rotman School of Management.

According to CREA, average Canadian house prices increased nearly 20% in 2009.   Did your income increase by that amount as well?   In 2010, Royal LePage forecast home prices would continue to “appreciate significantly” during the early months of the year.

So how exactly is it premature to speak of a housing bubble when we’ve already experienced a 20% annual increase, with even higher prices on the horizon?

It is likely, though, that a significant part of the surge in housing sector activity is associated with temporary factors – notably the historically low borrowing costs, as well as pent-up and pulled-forward demand – which cannot continue to drive increases in house prices and activity.

Surge. Temporary. Cannot continue to drive increases. So, according to the BoC’s viewpoint, when the pent-up and pulled-forward demand has been used up and the temporary factors such as low interest rates are no longer in play, housing prices will just stabilize? I haven’t seen many economic models that show a Boom-Plateau-Boom cycle.

This discussion leads to the following question: if the Bank did see the housing market posing a possible threat to financial stability, what should we or other authorities do about it? Some observers – those who see a housing bubble forming – have said that since low interest rates have stimulated housing market activity, the Bank should now raise interest rates to dampen that activity.

There is no housing bubble, and it’s premature to speak of a housing bubble, but let’s discuss what the Bank of Canada should/could do to stop a housing bubble (which there isn’t) if there were one.

If the Bank were to raise interest rates to cool the housing market now – when inflation is expected to remain below target for the next year and a half – we would, in essence, be dousing the entire Canadian economy with cold water,

Cool the housing market? Why would you want to cool a market that’s “in line” with “underlying fundamentals”? Why not let the healthy housing market play out normally?

Ok, so raising interest rates would cripple the rest of the economy. Understandable. So, what can we do?

An array of supervisory and regulatory instruments can be used by the government to restrain a buildup of systemic risks. These include capital requirements for institutions, leverage ratios, loan-to-value ratios, terms and conditions for mortgage insurance, and a variety of other measures. These instruments can be targeted to risks to the entire financial system that stem from particular markets or institutions…

In Canada, a system-wide, or macroprudential, approach is the shared responsibility of the Department of Finance and all of the federal financial regulatory authorities, including of course the Bank of Canada, the Office of the Superintendent of Financial Institutions, and the Canada Deposit Insurance Corporation. Ultimately, it is the Minister of Finance who is responsible for the sound stewardship of the financial system.

Zing! Take that Flaherty. Low interest rates aren’t the cause of the Canadian housing bubble (which doesn’t exist).

It’s the Minister of Finance’s responsibility. Ah, like Pontius Pilate of old, the Bank of Canada seems to be washing their hands of whatever outcome awaits.

The revival of housing activity is a reflection of the historically high level of affordability that is associated with the current record-low interest rates.

Wait, what? I thought interest rates weren’t the cause – what happened to “underlying fundamentals” and all that?

I guess I can see why it’s “premature” to speak of a housing bubble from the Bank of Canada’s view from the following statement:

The housing sector is a crucial part of the Canadian economy, and it typically plays a disproportionate role in economic cycles. Housing wealth provides collateral for household borrowing and spending. Increases in the cost of housing are an important element in consumer price inflation, and demand for housing is a gauge of household confidence.

Essentially the conclusion I gathered from the speech is: Current house price increases are good for the economy, but the Bank of Canada can’t be held responsible for the ensuing housing bubble.

Last month, when Mark Carney was asked about the potential for a bubble in the housing market, he reiterated that the central bank’s core focus remains fixed on inflation. “Monetary policy in Canada doesn’t target specific assets or asset prices,” he said. “It will be set to achieve the 2 per cent [inflation] target.”

If home prices rise uncontrollably due to low interest rates, so be it, as long as inflation is on target.

You can read the entire speech here
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Here’s where I think it gets even more interesting.

David Wolf, now with the Bank of Canada, used to be an economist with Merrill Lynch.

Let’s rewind to 2008, before the BoC was his employer, and see what his thoughts on the housing market were then:

It may just be a matter of time before the Canadian housing market tanks like the U.S. market did, Merrill Lynch Canada economist David Wolf said, warning that Canadian households are now nearly as overextended as households in the U.S., and even more so than those in Britain, prior to the bursting of the housing market bubbles in those countries.

“What worries us is that Canadian households have been running a larger financial deficit than households in either the U.S. or the U.K.,” Wolf said in a commentary, noting that in 2007 Canadian household net borrowing amounted to 6.3 per cent of disposable income, which was higher than in Britain and not far off the seven per cent peak in the U.S. in 2005, prior to the bursting of that country’s housing bubble.
-September 2008

In Feb ‘09, Deloitte & Touche warned that the ratio of debt to disposable income had increased to a higher percentage than that of American consumers.

Throughout 2009 Canadians continued to pile on the debt. The household debt-to-income ratio rose two points to 145% – the highest level since quarterly record keeping began in 1990. That means for every $100 of personal disposable income, Canadians now carry $145 in debt, compared with $88.60 in 1990.

[David Wolf] estimates that markets with the strongest price growth in recent years, such as Regina, Saskatoon, Vancouver, Victoria, Calgary, Edmonton, Sudbury, Ont., and Montreal, were all more than 10 per cent overvalued.
-August 2008

So, with the Canadian residential average price in major markets surging 20% more in 2009 (11% if you use CREA’s weighted average) how overvalued are they now exactly? Locally, the average Calgary house in August 2008 was $440,625 with a median $398,000 – slightly below last month’s figures.

In February 2009 David Wolf said:

“I know that the conventional wisdom uniformly shared is that Canada will fare better than the U.S., but I wouldn’t be so sure,” says David Wolf, chief economist for Merrill Lynch, one of the first private-sector analysts to predict a house price collapse in Canada.

So why are thoughts of a housing bubble premature when factors Mr. Wolf considered important a few months ago have gotten even worse?

Going back to his speech in Edmonton today, one last point I wanted to touch on was the following statement:

But with the recession and tumbling commodity prices, a housing market correction was inevitable. The correction was much steeper, though, for regions that had previously experienced the largest increases. Here in Alberta, as you know, the drop in prices has been larger.

Yes, it would make sense that there would be a housing correction during a recession. But there wasn’t.  The biggest price drops in Calgary didn’t happen during the recession, they happened earlier. During the recession, Calgary house prices did this:

click to enlarge

Or, if you prefer using the Teranet-National Bank HPI, year-to-date up until October 2009, Calgary house prices were down 2.12%, or -3.61% year-over-year.   Hardly the definition of a market correction.  Is it yet to come?

If the Bank of Canada says there isn’t a housing bubble there must not be one, right?  After all, they correctly predicted there would be no recession in Canada and that Canadian credit conditions were superior to the US and Europe and no new money would need to be injected into the system.

Oh wait…

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Your insight and thoughts on this are appreciated.

Edit:  Read Garth Turner’s thoughts on today’s speech here.