Why Canada’s Housing Market Didn’t Burst

Tuesday, 16 February 2010
Housing markets in the United States and Canada are similar in many respects, but each has fared quite differently since the onset of the financial crisis.Unlike the U.S., Canada has not experienced a dramatic increase in mortgage defaults, nor has any Canadian bank required a government bailout. As a result, observers such as The Economist have pointed to Canada as “a country that got things right.”

The different housing market outcomes in Canada and the U.S. can tell us something about the underlying causes of the housing boom and subsequent bust in the latter. In particular, they can be used to evaluate the roles that low interest rates and relaxed lending standards played.

Monetary Policy and the U.S. Housing Bust Some observers blame monetary policy for lowering interest rates over 2002-2005, pushing up housing demand, increasing residential investment and raising housing prices. In this view, the monetary-policy induced housing boom thus set the stage for an inevitable housing bust.

The low interest rate policy of the Federal Reserve over 2001-2005 is often cited as a key factor in the U.S. housing bust. The main narrative is that by lowering short-term interest rates, longer-maturity mortgage interest rates are pushed down. This increases the demand for housing, puts upward pressure on housing prices and encourages builders to ramp-up construction of new homes. This leads to an “oversupply” of new homes, which triggered the housing bust in the U.S.

There are also claims that interest rates were too low over 2001-2005, when looked at by both historical standards, as well as compared to those predicted by the Taylor rule (a monetary policy rule which relates U.S. Federal Reserve’s ideal target rates to inflation and GDP).

The Bank of Canada made dramatic reductions in its target interest rate over 2001-2002, but one might argue that Canadian monetary policy was not quite as “loose” as that in the U.S. as it maintained a higher overnight rate over 2002 to 2004.

But a case can be made that Canadian and American monetary policies were very similar, at least in terms of the housing market. Estimates put the deviations from the Taylor rule for Canada and the U.S. over 2001-2006 to be nearly identical. In fact, the two benchmark mortgage interest rates move closely with one another until after the beginning of the U.S. housing market crisis, when U.S. rates fell significantly below Canadian rates.

Mortgage interest rates-the main direct channel through which monetary policy impacts the housing market-tracked each other closely in the two countries, but unlike the U.S., where the mainstay of the mortgage market is the 30-year fixed mortgage, the most common mortgage product in Canada is a five-year fixed-rate mortgage (with a 25-year amortization period).