No housing bubble in Canada -- yet

Some observers have pointed to the risk of a Canadian housing bubble -- a situation where the level of house prices is based primarily on extrapolative expectations that house prices can only rise further. Housing bubbles are usually fueled by credit expansion, as borrowers and lenders take false comfort from exaggerated house prices. Generally, when there is a rapid rise in asset prices, including house prices, one should always ask whether they have increased too far, too fast.

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. Moreover, with housing starts below long-term demographic requirements, inventories are still declining. 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. Thus, we see the housing market as requiring vigilance, but not alarm.

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.

But that poses a problem. As I've stressed, we have a mandate to use our key interest rate to achieve our inflation target -- and the housing market is only one of several factors that influence inflation. 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, just as it emerges from recession. As a result, it would take longer for economic growth to return to potential and for inflation to get back to target. This is why we say monetary policy is a blunt instrument for achieving financial stability.

So what other instruments are available? An array of supervisory and regulatory instruments can be used by the overnment 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.

Using these instruments to safeguard the whole financial system -- not just individual institutions -- is the essence of the macroprudential approach. Macroprudential supervision is one of several concepts in a current global initiative to strengthen supervision and regulation in the wake of the global financial crisis. 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.

Prudent, conservative policies have provided significant support to Canada's housing market through both good times and bad. This point has been amply demonstrated, during the recent recession -- where many countries saw imbalances roil their housing markets -- and in the ongoing recovery here in Canada. The current revival in our housing sector was a desirable, and intended, part of Canada's economic recovery, but like all good things, it must be carefully monitored to ensure that it doesn't go to an extreme.

(prepared by Timothy Lane/Financial Post/National Post)