BCREA Bulletin _February 2010_

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BCREA Bulletin _February 2010_ Powered By Docstoc
					Economics
  The armchair analyst:
  mortgage interest rates
Housing affordability has a significant   keep inflation between one and three
impact on housing markets. One            per cent with a target of two per cent.
does not need to be an economist to       The Bank adjusts its trendsetting
understand that as the carrying cost      target overnight rate, the one day rate
of home ownership increases, some         at which it lends to major financial in-
potential homebuyers will be unable to    stitutions, in order to stimulate or slow              By Cameron muir,
qualify for mortgage financing.           the economy and inflation. Thus, the                   BCrEa Chief Economist
Housing affordability is often reported   higher inflation typically associated
as the gap between the price of a home    with an overheated economy means            not create an equivalent decline in
and household income. For example,        that short-term interest rates will         fixed mortgage rates. The fallout
“the average home price is ten times      increase. The recent financial crisis       from the subprime mortgage debacle
the average income”. It is also com-      created the opposite situation. Fear of     widened the risk premium attached
monly reported that since the current     a severe contraction in the economy         to mortgages, exceeding 400 basis
gap is head and shoulders above the       and the potential ensuing deflation led     points (+4.0 per cent) at the time.
long-term average, home prices must       the Bank to slash its trendsetting rate
decline to match this so-called funda-    to 0.25 per cent in order to stimulate      A key determinant of mortgage
mental long-term average. This type       the economy.                                interest rates is inflation and expected
of analysis ignores one basic fact;                                                   inflation. High inflation means the
housing affordability is not just a       Both short and long-term fixed              Bank of Canada will raise its target
function of incomes and home prices,      mortgage rates move in tandem with          overnight rate to put the brakes on the
mortgage interest rates also play a key   deposit rates and bond yields of            economy. Bond investors will also
role. Mortgage rates have been on a       similar maturity. Since a mortgage          require higher yields in order not to
downward slide for more than 25           embodies more risk than a bond, a           lose ground. With interest rates at or
years, enabling a much larger gap         premium is attached to a fixed mort-        near historic lows, there is little doubt
between home prices and household         gage rate. For example, 5-year fixed        that economic recovery will induce
incomes.                                  mortgage rates are typically around         inflation and higher mortgage rates.
                                          250 basis points (+2.5 per cent) above      How long will it take for the economy
Interest rates are an important           the 5-year bond yield. However, there       to once again fire on all cylinders and
determinant of housing demand. Their      are exceptions. The financial crisis        will higher interest rates mean trouble
impact on your mortgage payment or        and sharp downturn in the stock             for BC’s housing markets? We will
carrying cost can be dramatic. In         markets had many investors fleeing to       explore these issues in the next
1982, when the 5-year fixed mortgage      low risk options such as bonds. The         installment of the Armchair Analyst.
rate hit a high of 22.75 per cent, the    resulting decline in bond yields did
housing market subsequently collapsed
with home prices falling 40 to 50 per
cent in many markets. The Armchair
Analyst is wise to pay close attention
to the direction and magnitude of
interest rates. While low mortgage
interest rates can be a powerful
engine of demand, as recent activity
demonstrates, very high interest
rates can virtually pull the rug out
from under any housing market.

The Bank of Canada, Canada’s central
bank, influences variable mortgage
interest rates. Its primary focus is to



      ThE BullETin • FEBruary 2010

				
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