Rate Hikes May Be Needed, But Do Canadians Have Enough Wiggle Room?

Sept 6 2012 by By Nirmala Menon



Canadian Finance Minister Jim Flaherty’s recent move to tighten mortgage rules may have taken some froth off the housing market and tempered demand for credit, but Bank of Canada Governor Mark Carney will still have to hike rates to deal with financial excesses in the household sector, economists at Toronto-Dominion Bank sa TD.T -0.07%id Thursday.

The government tightened mortgage insurance rules this summer for the fourth time since 2008. Before Mr. Flaherty announced the measures, TD had expected house sales and prices to correct around 10% starting in mid-2013, on the assumption the Bank of Canada would hike rates by 100 basis points over the next year, and another 50 basis points in 2014.

Mr. Flaherty’s action reduces the urgency for Mr. Carney to pull the rate-hike trigger anytime soon, but as long as borrowing costs remain so low, there’s “powerful incentive” for Canadians to take on additional debt, TD said.

The Bank of Canada deems household debt – currently at record levels – to be the biggest domestic risk to the economy. Mr. Carney said in a speech two weeks ago that the Bank “is prepared to support regulatory efforts, if necessary.”

According to TD, “higher interest rates will ultimately be required over the next few years to ensure that Canada’s housing market and overall economy remain on a sustainable growth path.” The Bank of Canada is the only major monetary authority contemplating higher rates, a message it repeated Wednesday when it held the benchmark overnight rate at 1.00% for the 16th consecutive time.

TD said the Bank of Canada is likely to hike rates by 50 basis points next year – half of what it had expected before Mr. Flaherty tightened mortgage rules. It sees further modest increases in 2014.

However, overextended Canadians have little wiggle room to afford higher borrowing costs, suggesting delinquency and default rates will rise, according to economists atMoody's MCO -2.24% Analytics, who also expect the Bank of Canada to hike rates before the end of 2013. They said Thursday that tighter mortgage rules will limit the rise in losses and prevent a crisis on the scale experienced by the U.S. during the recent recession.

“Nevertheless, with the economy now relying heavily on the continued expansion of household spending, any retrenchment in the consumer sector will likely place the economy on the brink of a second recession, creating the potential for a much more serious downward spiral in employment, household spending, and the quantity and quality of outstanding credit,” Moody’s Analytics said.

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