Since our second quarter forecast, our projected rise in mortgage rates has occurred and accelerated, as the Bank of Canada—spurred by economic growth that far exceeded its outlook—turned suddenly hawkish. The Bank surprised with a 25-basis point increase in July and then again in September, taking its overnight rate back to 1 per cent, where it was before the precipitous drop in oil prices that shocked the Canadian economy in 2014. After the July interest rate hike, markets widely expected at least one additional rate increase in the fall, and so bond markets and lenders had already priced in the September increase by the time it occurred.
Given the rapid expansion in the Canadian economy, it is clear the stimulus introduced to offset falling oil prices is no longer required. However, the policy direction going forward is less clear, given the chronic undershooting of the Bank’s inflation target over the past year.
If sustained economic growth and a closing of the current output gap bring higher inflation, the Bank will likely embark on a more sustained cycle of rate increases to close the wide gap between its current target rate and its estimate of the “neutral” rate at which the economy runs neither too hot nor too cold. The Bank itself estimates that neutral rate in a range of 3 per cent to 3.5 per cent, which means a further 200 to 250 basis points of tightening in the future. However, should inflation remain stubbornly low, the case for rate hikes loses some urgency. Our baseline forecast is for gradual rate increases over the next two years, with the Bank of Canada’s overnight rate ending 2018 at 1.5 per cent.
Copyright British Columbia Real Estate Association. Reprinted with permission.