Today we are bringing together two traditions – one old, one new. The old tradition, which lasted more than a decade, saw the Canadian Central Bank talking about the state of our financial system at the end of a year-long speech in Toronto. The more recent tradition, which began earlier this year, presented an Economic Progress Report four times a year, Monetary Policy Report (MPR), like yesterday.
My motivation to bring these two traditions together is more than just trying to increase productivity. A decade ago, the global financial crisis gave us preconditions for the repetition of the Great Depression of the 1930s. We avoided this through aggressive fiscal and monetary policies. However, a large monetary stimulus that lasted more than ten years brought us to a critical stage in the economic cycle.
The Canadian economy has been operating close to its capacity for more than a year, unemployment has been the lowest for decades and inflation is targeted. Historically, this is the point in the business cycle in which inflation pressures will begin to be created, so it is natural for us to move the interest rates to a neutral level. At the same time, ten years of extremely low interest rates have led to an increase in household debts, mostly composed of mortgages. In recent years, we are particularly aware of the large increases in housing prices in our largest cities.
These financial fragilities have made monetary policy more complicated. Understanding these and integrating them into our policy process has been a priority for the Bank. By the way, since the last MPR in October the world still did not stop. Indeed, there have been more macroeconomic developments than ever before. My focus today is to show you how to address the concerns of financial stability in our decision-making process by bringing you today.
Financial weakness growth
Let me start with a few words on how our financial vulnerabilities begin. The fact is that the debt occurs in the recovery phase of each economic cycle. Low interest rates promote a recovery by encouraging the borrowing of households and firms. Normally, the economic cycle is the relatively small risk of these imbalances.
Of course, the last 10 years were far from normal. Interest rates have been exceptionally low for an extraordinarily long period of time. The inevitable result has been a strong demand for the accumulation of household debt in housing, rising housing prices and historical rates. Relevant accumulation in financial fragility has been the Bank's occupation for several years. Indeed, household debts in Canada were rising strongly before the global financial crisis, as a result of mitigation of mortgage rules 15 years ago, financial innovation and declining interest rates.
In response to these developments, the federal government has implemented a number of more restrictive macroprudential policies designed to make new borrowing more secure. In particular, in the revised B-20 guidelines, which came into force earlier this year, all new mortgage borrowings from federally regulated institutions were subjected to a kind of stress test in order to overcome the increase in interest rates of borrowers. You can find more details about these and other stability issues in our Financial System Center on the Bank's website.
Now, I always hear people who say that this stress test should not be applied in non-overheating housing markets. But the goal of the B-20 was not to cool down the housing markets. The issue was to increase the future flexibility of the new household debt. Not all Canadians are at risk of higher interest rates, not only in hot housing markets.
Nevertheless, there is no doubt that these stress tests, high interest rates and the combination of housing policies implemented by provincial and municipal governments affect household borrowing. We see that much less mortgage is received in debt-to-income ratios of over 450%. And credit data shows that mortgage lending growth slowed down at a rate of over 3 percent this year. At this rate, the total debt-to-income ratio is likely to result in a moderate downward trend.
In determining the monetary policy, it is very important to solve the effects of these various policies. We need to know how much of the slowdown in credit growth is due to higher interest rates than other policies. How big are the high interest rates on household expenditures? Also, how do the various macro prudential policies, including the B-20 guide, affect the behavior of borrowers and home builders?
Obviously, there is no way to get definite answers to these questions. However, we need to understand how the developments in the financial system affect the real economy and the risks it faces. I talked about it four years ago during a lecture at West University. I talked about the idea of developing a great synthesis – a utopian economic model that helps the financial system to affect the real economy and, conversely, help us fulfill our inflation control task.
We can never reach that utopia. But the good news is that we've made significant progress. Let me tell you about three important developments.
First of all, a new concept developed in the International Monetary Fund (risk-based growth) is currently being used by Bank staff to help us understand the links between the financial sector and the real economy. It captures the increase in financial fragilities and the downside risks of economic growth associated with them. Accordingly, when considering a change in interest rates, we can estimate both indirect effects on the economy and indirect effects through financial fragility. The growth framework at risk is not a great synthesis, but our risk management has provided a more rigorous view of the financial fragilities in our policy framework.
Second, it raised the basic economic model to include household debt accumulation, thus revealing the fact that the economy is more sensitive to interest movements when the debt levels are high. It also includes the link between debt accumulation and rising housing prices. These are important steps to help us understand the impact of these vulnerabilities on the economy.
Third, bank staff are working with new micro-data sources to understand how high interest rates affect mortgage holders. We now have access to anonymous data at an individual credit level that extends to about 2014 percent of mortgage debts from this period. This includes information on the size of the mortgage, household income, interest rate based on the interest, duration of the mortgage and the period of redemption.
These data allow us to calculate how mortgage loans are affected by higher interest rates through the mortgage renewal cycle. By estimating the effects of high interest rates on monthly household expenditures, we can predict how the expenditures on other purchases will be affected.
So far, this advanced framework has performed well for our estimators. However, it is important to remember that most of the households have been renewed in mortgage rates, which are very similar to the rates they recorded five years ago. As we move forward, people will face more with higher interest rates while renewing and we will learn more about how people are set up.
It is clear that many high-debt households will face a difficult alignment due to the resettlement of their mortgages and the rise in interest rates. However, these arrangements would be much less demanding, especially if there was a serious negative economic shock if financial vulnerabilities were allowed to continue uncontrolled growth.
Now, the fact that household spending behaves roughly as expected, gives us more confidence because we understand what is happening in the economy. But debtors and lenders continue to adjust to rising interest rates and new mortgage rules. Therefore, we closely follow a series of trends in the mortgage markets. For example, the share of mortgages arising from federal jurisdiction, including private creditors and credit unions, is increasing. These borrowers are not subject to an official interest rate stress test. Although we do not have such data for cities outside Toronto, we have seen the mortgage share increase given by private lenders in the Toronto area.
In addition, we received a larger share of borrowers with higher-interest mortgage loans. In doing so, they reduce the burden of debt-service, because the interest rate on a mortgage with a variable rate is usually lower than a flat-rate mortgagetan. This saves money for spending or saving in the short term, but exposes debtors to unexpected increases in interest rates. However, on-site stress testing gives us confidence that these debtors can manage significantly higher payments when needed.
In sum, while the quality of new loans is improving, risky mortgage stock remains high. Over time, these mortgages should become less risky as they will be paid slowly. Nevertheless, this vulnerability will continue for many years.
Developments in housing markets, which are closely related to the increase in household debt. Everyone is talking about it – it's no surprise that the prices in the Toronto area are 40 percent higher than three years ago. In the Vancouver region, the increase has increased even more – about 50 percent. Out of these two areas, the average housing price has increased only 5 percent in the same three years.
To be clear, the main factors have increased home prices in Toronto and Vancouver. Strong population and employment growth supported housing demand. The cost of various inputs, such as construction labor and development fees, has also increased. At the same time, the increase in supply of various policies and other factors in both regions remained limited. If the demand for supply does not grow in a strong demand environment, you have a recipe for rising prices.
It was clear, however, that the price increase in 2016-17 was mainly enlarged by speculative activities. Some buyers have stepped up their purchases due to the fear that they will be priced on the market if they wait. Others, primarily investors, were buying real estate on the assumption that prices would continue to rise. This is important, since speculative activity can lead to a sustained increase in prices, leading to a sharp drop in economic shock. In the early 1990s, everyone who remembers the housing market in Toronto and Vancouver will recognize this point. And the impact of such a fall is growing when the landlord is quite indebted.
The Bank increased the policy rate by 5 times and 125 basis points in total compared to the previous year. And I've heard more than some Canadians that they're concerned about the impact of increases on housing affordability. However, considering the combined impact of state and municipal housing measures and the tightening of macro-prudential policies, not to mention higher interest rates, housing prices as a whole for Canada are growing at a rate of around 2 percent. In my opinion, this slowdown in home price inflation is, for the first time, more economic than the interest movements that we see for our employees. The basic laws of economics say that measures to increase supply will be the most effective way to support affordability. Measures that increase demand without a corresponding increase in supply may worsen the availability of housing.
When we talk about the rise in interest rates, a risk associated with Canada's financial stability is a spike in global interest rates. As Canada will generally import around 60 to 70 percent of the increase in global bond yields, we see impacts on our mortgage rates, despite the fact that the Bank of Canada policy rate has not changed. This risk, especially in the last weeks, especially considering the volatility of bonds and stock market continues to be in mind. Most observers will argue that the possible catalyst for such a risk would be an inflation surprise that came from the US and increased the response of the US economy to financial stimuli. However, our outlook shows that the US economy will move towards a more sustainable pace by next year and by 2020 and that inflation expectations will be well protected.
So let's summarize the financial stability situation. The Governing Council states that the overall risk level for the Canadian financial system is the same as six months ago, Financial System Review. New mortgage lending was more robust, and housing prices slowed down. However, the stock of household debt will remain high for years, and in some markets housing prices rise. Our new growth framework at risk shows that macro-prudential policies are working to reduce the risk of financial stability, thus improving the risk management problem faced by monetary policy.
Macroeconomic risks and inflation outlook
Let's turn to macroeconomics. As stated in October, the economy has been operating close to capacity for more than a year and inflation is targeted. There have been many important developments since October.
First, concerns about the global economic slowdown are increasing. I would like to point out that our forecasts are moderating economic growth in 2019-20, but this will not only lead to a sustainable growth path and create concern. On the other hand, the biggest risk we see from this point of view is the trade tension between China and other countries.
Rising tariffs will slow economic growth and reduce productivity on both sides, and increase against inflation as well as inflation. This combination is particularly difficult in terms of monetary policy because it forces a balance between the equilibrium of economic growth with lower interest rates and the inflation risk with higher interest rates. Since I believe that the effects of the economy will be structural rather than cyclical, I have to believe that inflation trade will be more important than anything else in a risky trade war.
Importantly, the risks of global trade are twofold. Yes, there is growing evidence that trade movements have already had adverse macroeconomic effects. However, as central bankers, we cannot focus only on the worst scenarios. The main risk is that the United States and China are hesitant and the global economy is a new source of lifts. The events at Buenos Aires this weekend were a little encouraging on this front. Thus, we continue to weigh both sides of the subject.
In terms of the Canadian economy, it is true to say that the data released since our October MPR was on the frustrating side. Although GDP data for the third quarter were generally close to our expectations, there was no composition underlying growth, and there was less momentum in the economy than we believe in the fourth quarter.
Although the latest data from the housing sector is softer than expected, we believe that this is a result of a significant alignment in single constructions to new constructions, and this arrangement extended the slowdown in housing construction that began earlier this year. The increase in population and employment and therefore the basic demand for housing remain strong. Credit growth continued and all of these support our view that the market has stabilized.
In the third quarter, business investment declined unexpectedly. Earlier this year, we identified the possibility that the uncertainties about the future of NAFTA would undo investment decisions. It is now seen that this effect is very strong in the summer when uncertainty is highest. The other major factor limiting business investment was the delay of the Trans Mountain Pipeline project.
The signing of the CUSMA will support a recovery in investments, especially given the capacity constraints, even though the government still needs to implement the agreement. In addition, the recent changes in the federal government's tax changes will further strengthen investment. This would also mean continued growth in exports, which are supported by strong external demand, but constrained by tight capacity.
In the most recent GDP collection, Canadian Statistics revised downward historical growth forecasts. Many of these revisions point to changes in the economic structure that began in 2015 because the economy was adjusted to the rapid decline in oil prices. It may seem strange that developments in 2015 could still affect our view of the economy in 2018, but it is. Today, it is believed that the level of GDP is about 1 percent lower than it was previously thought. The impact of this revision on the inflation outlook will depend on how much of this shift is demanded and how much is in supply or economic capacity, and hence how the difference between the two is affected. Once our analysis is complete, we'll give more information about this in our January MPR.
Most of the discussion of the Council of Management focused on oil. Global oil prices are largely below our forecasts for October MPR, largely due to their supply power. With the impact of future oil demand, given the growing trade tensions, there is also a major concern in moderating global economic growth.
The main source of additional oil supplies was the same with the United States in 2014. As a reference, the world consumes about 100 million barrels of oil per day. US production in 2008 was 7 million barrels per day. The revolution with the deed increased this figure to 12 million by 2014. Today US production is more than double the level of 2008, more than 15 million barrels per day. This is only 2 million more than a year ago and US oil exports so far increased in the same amount.
These US developments are dwarf production in Canada – producing about 5 million barrels per day and exporting over 3 million. Weak global oil prices, as we know from our experience in 2015-17, directly affect Canada. This affects all producers in the east and west. Although the Canadian economy has largely adapted to the decline in oil prices in the middle of 2017, regulations on cost structures, wages in oil-producing regions and employment-related arrangements have continued. Indeed, the share of oil and gas production in the Canadian economy has decreased from about 6 percent today to 3 percent since 2014.
The recent decline in world oil prices grew in Western Canada as a record-breaking expansion of our heavy oil Western Canada Select. This is largely due to transport restrictions, but this autumn was combined with maintenance downtimes at some important American refineries. Since our October decision, the US oil refineries fell again, while the heavy oil allowance fell slightly. However, in recent weeks, the price of Western Canadian light crude oil, Edmonton Par, has also risen to record high inventory levels. Alberta's attempt to implement exit reductions and provide more railway capacity will help to eliminate backlogs, and in the long run more pipeline capacity will certainly help.
Although we have not prepared an entirely new economic forecast for yesterday's decision, we will do so in January between our current and next decision. It is clear that a painful harmony is developing for Western Canada and there will be a significant impact on macroeconomics in Canada. In the consolidation in the energy sector since 2014, low oil prices have to be smaller than the Canadian economy as a whole, with a net effect for the dollar as of 2015.
In a nutshell, as I said, October has been a lot since our MPR. However, let's not forget that these developments have reached a goal that is compatible with an economy close to a low unemployment rate of 40 years and an inflation and capacity close to its target. We will consider all of these new developments in our new projections in January MPR.
The Governing Council has determined that current interest rates are appropriate for the time being. In order to achieve the inflation target, we continue to determine that the policy rate should rise to a neutral range between 2.5 and 3.5 percent. The speed at which this process takes place, of course, will certainly depend on the data. We will continue to measure the impact of higher interest rates on consumption and housing and to follow global trade policy developments. The continuation of the oil price shock, the development of business investments and the assessment of the capacity of the economy will play an important role in our decisions regarding the future stance of monetary policy.
It's time for me to conclude. I hope my speech has shown you how financial fragilities fit into our monetary policy discussions. We've made progress in thinking about these and other vulnerabilities, and we've come to understand the risks they bring to the economy. I've also tried to understand the many issues we've laughed while managing the macroeconomic risks facing the Canadian economy. We will continue to manage these risks while maintaining the task of controlling inflation and promoting the economic and financial prosperity of Canadians.
I wish you all a very happy holiday season and the best in the new year.
I would like to thank Don Coletti for his help in preparing this speech.