Bank of Canada study says ignoring shelter inflation in demand-driven boom worsens overvaluation

A new Bank of Canada staff paper concludes the central bank cannot safely ignore shelter inflation when it is driven by housing demand, as doing so worsens price overvaluation and economic volatility. The research also finds that while interest rate cuts do stimulate more home construction, roughly 80 percent of that increase comes from boosting housing demand rather than lowering builders' financing costs. The paper tests common arguments from the real estate industry that the bank should look past shelter inflation and keep rates low to boost supply, finding neither holds as a blanket rule. The researchers modelled a housing boom where prices climb 20 percent over two years. They found that excluding shelter inflation from monetary policy decisions pushes overvaluation as much as 2.2 percentage points higher than a policy that includes it. When buyers have "extrapolative expectations", assuming a trend will continue, the overvaluation gap is about 70 percent larger than when expectations are rational. "This amplifies financial stability risks, especially when price dynamics are partly driven by past increases in house prices," the researchers warn.

"Monetary policy should not look through shelter inflation when it is driven by housing demand shocks," they explain. "Looking through creates a more volatile economy especially when faced with extrapolative expectations." The paper states that factoring shelter inflation into rate decisions during a demand-driven boom makes an interest rate hike more likely, which would cool demand over time. On the supply side, the study modelled a 100 basis point rate cut, which increased residential investment by 6.2 percent. However, cheaper financing for builders accounted for only 1.4 percentage points of that increase, or roughly 20 percent. The remaining 80 percent came from excess housing demand stimulated by the lower rates. "While financing costs do affect housing supply, supply-side cost effects remain quantitatively secondary to demand-driven mechanisms operating through house prices and expectations," the researchers explain.

The paper also examines a unique Canadian problem: the inclusion of mortgage interest costs in the Consumer Price Index. This creates a "policy amplification loop" where a rate cut lowers mortgage interest costs, which then lowers measured inflation, potentially prompting the central bank to cut rates again. The researchers say this feedback loop reinforces a housing boom, making a case for excluding mortgage interest from inflation measures even as they warn against ignoring other demand-driven shelter inflation. The dynamics change when a supply shortage is the main driver of shelter inflation. In that scenario, the model shows that raising interest rates "does little to reduce cumulative shelter inflation" because higher mortgage interest costs and rising rents offset cooling in home prices. Total headline inflation ends up nearly identical whether the Bank of Canada reacts to shelter inflation or not. However, reacting with rate hikes leads to a larger decline in overall economic output. "This trade-off suggests that looking through housing supply shocks may be welfare-enhancing," the researchers conclude, though they add a caveat. They warn that if a supply shock persists, the risk of de-anchoring inflation expectations rises, urging caution. The paper is clear that rate cuts are not a housing supply strategy, and that the central bank faces complex trade-offs depending on what is driving shelter inflation.

With files from Better Dwelling