In a report out today, the C.D. Howe Institute argues that the Bank of Canada needs a new inflation indicator that better reflects changes in housing prices. As housing prices have shot upwards in Canada, inflation as measured by the Consumer Price Index (CPI) has shown only moderate increases.
C.D. Howe analyst Philippe Bergevin states that the main concern is that the CPI’s insensitivity to housing could potentially cause the central bank – reassured by its imperfect indicators that inflation is under control – to keep rates too low for too long.
Drawing comparisons to the US home market, the report goes on to say:
In Canada, the recession was less severe, and the Canadian financial system has proven much more resilient. Observers have pointed to many factors inexplaining this good showing: they include a more prudent and effective approach to the regulation of the financial system, a sounder mortgage legislative framework, and more conservative banking practices.
However, Canada is not immune to a failing that may have contributed to the US housing bubble: the relative insensitivity of the inflation indicator to housing prices, which is a problem in both countries. The US Federal Reserve Board’s favored inflation indicator – the price index for personal consumption expenditures – is quite insensitive to changes in housing prices because of the way its housing component is calculated. Hence, it did not capture well the recent housing boom and bust.
Similarly, the Bank of Canada’s inflation measure, the Consumer Price Index (CPI), is relatively insensitive to housing price changes, and does not, for example, capture fully the recent run-up in
Rates that are kept too low for too long could, arguably, encourage excessive lending, and notably mortgage lending, which can help sow the conditions for an unsustainable rise in housing prices, and an ensuing bust. For instance, low interest rates in the US in the early 2000s likelycontributed to excessive credit growth and, in turn, to the spectacular rise in housing. Had the Fed’s preferred inflation indicator been more reflective of the housing boom, other things being equal, it might have felt compelled to tighten monetary conditions sooner and more sharply.
The answer seems simple enough, doesn’t it? Raise the rates and now. Not so fast:
Going forward, however, given that the Bank of Canada sets its policy rate on a forward-looking basis, and that housing prices are expected by many to decline or at least level off in the medium to long term, the use of the proposed indicator would actually supprt the case for continuing to keep rates at historically low levels.
You can read the entire report here