Bank of Canada can't solve housing crisis, Tiff Macklem says

Governor says housing affordability can’t be fixed by raising or lowering interest rates

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Rising shelter costs are now the biggest contributor to above-target inflation, but Bank of Canada governor Tiff Macklem said the central bank is powerless to address them. That was just one of the limits of monetary policy that Macklem outlined in a Feb. 6 speech before the Montreal Council on Foreign Relations about what the bank can and can’t do — a topic that has taken on urgency as the public and policy makers clamour for solutions to issues such as housing affordability. Here are three key takeaways from Macklem’s speech.

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Interest rates can’t solve the housing crisis

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Housing affordability cannot be fixed by raising or lowering interest rates, the Bank of Canada governor said. Shelter price inflation has been elevated for several years and increased further in the past six months. But none of the underlying reasons behind the country’s housing supply crunch can be addressed by monetary policy, Macklem said.

He said that while shelter price inflation partly reflects the impact of increases in the central bank’s policy rate on mortgage interest costs, it also reflects increases in rents and other housing costs, which are more related to the structural shortage of housing.

“That is not something monetary policy can fix. But it is something we need to understand and factor into monetary policy because it is affecting the cost of living for Canadians,” he said.

While monetary policy has big effects on the housing sector and changes in the policy rate affect demand for housing very quickly due to their influence on mortgages, Macklem said the effects of monetary policy on supply are much more limited.

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Those shortages, in combination with the recent increase in the number of newcomers to Canada, also mean price gains that normally would have reverse by now have only declined modestly.

The pandemic proved monetary policy can control inflation

Canada experienced the deepest recession on record and inflation fell sharply at the start of the pandemic, Macklem said. The economy then had the fastest recovery ever when it reopened.

He said that amid the huge swings in the economy, monetary policy has shown it has the power to control inflation over the medium term.

“The last few years have caused some people to question monetary policy. That’s not surprising,” he said.

Combined actions by governments in rolling out fiscal stimulus and the Bank of Canada in cutting the policy rate to near zero helped keep the economy going and avoided deflation, Macklem said.

He added that they probably could have begun withdrawing stimulus sooner, but that even if they had, the impact on post-pandemic inflation would have been minimal.

Hitting the two per cent inflation every month

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Because interest rates affect everyone in every nook and cranny of the economy, Macklem said they inevitably influence demand and inflation.

Adjusting only one interest rate in the entire system sets in motion an effective chain reaction that ultimately controls inflation — but it doesn’t work immediately.

Rather, he said, monetary policy works with a lag of more than a year. This means that by the time a policy change affects inflation, the relative price shock that caused concern has typically run its course.

Those relative price shocks are fluctuations in specific prices, often for energy and food, because of things like geopolitical events, droughts and transportation disruptions. As long as these don’t broaden into more generalized price changes, they have a temporary or transitory effect on inflation, he said.

Macklem noted that central banks can’t prevent short-run fluctuations in inflation caused by these relative price shocks.

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“We typically look through them, since reacting would add even more volatility,” he said.

Recognizing that there will be temporary fluctuations, he said the bank aims for the centre of its one per cent to three per cent band, so inflation is in the band most of the time.

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