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Cutting interest rates would reduce housing costs—and inflation

High housing costs are the key driver of inflation in Canada, and the biggest immediate driver of housing costs are Bank of Canada interest rates

March 5, 2024

3-minute read

The rising cost of living in Canada shows up in a lot of ways, from daily expenses like food to less regular services like travel. But the most important place where costs have been rising—and the key driver of inflation overall—is in housing. This isn’t just for homeowners, it's also about renters—rent or mortgage payments take up a huge chunk of Canadians’ budgets at the best of times, and these are not the best of times.

The price of housing has skyrocketed via two sources in the Consumer Price Index (CPI)—mortgage interest costs and rent. Mortgage interest costs are up 55 per cent since March 2022 when rate hikes started, and we’re still not even halfway to how bad those increases will get. By June 2024, half of mortgage holders will have had to renew at higher rates. Many mortgage holders are on five-year fixed rate mortgages, which haven't needed renewal yet—but as the clock ticks and rates stay high, more and more of those mortgage holders renew at inflated rates.

Rents, for their part, have gone up 12 per cent since March 2022, according to the inflation index. This number is artificially low compared to mortgage interest because of “quality adjustments” made to the inflation index growth rates. For example, if a tenant is in an older building that was torn down and a new one is built at 25 per cent higher rent, but it was a 25 per cent better building, then the rent increase is zero from the perspective of the inflation index.

In reality the cost of a new lease has exploded in the past year—up 40 per cent in Toronto and 34 per cent in Vancouver in a single year (‘Turnover units’ in Table 6). The average increase last year alone for the country was 24 per cent. It’s hard to understate this—these are radical changes in rental affordability.

Rent is also tied to interest rates. As landlords see their own rising mortgage costs, they push those onto tenants through rent increases. Also as people who might want to buy can’t due to high mortgage costs, they stay renting for longer. And as with mortgage interest costs, we’re nowhere near the end of rapid rent hikes. Landlords have also been protected by five year fixed rate mortgages that they will have to renew at higher rates in the coming years. This will keep driving rents up for years to come.

Economists’ simple economic argument is that higher interest rates always means lower inflation. The story is that consumers will spend so much more on some goods that are directly impacted by rate increases that they will have nothing left to spend in others—and so, on the whole, inflation will moderate. This is a story only an economist can love. Does this still hold when Canadian households are the most indebted in the G7?

It's not lost on average Canadians—although maybe it is on economists—that one of the drivers of high inflation is high housing costs, which are directly related to the Bank of Canada’s interest rate hikes. Instead of high interest rates curing inflation, they’re causing it.

This can actually be tested—just remove housing cost components from the inflation index, and see if they’re causing inflation. Without mortgage interest and rent, inflation has actually been between one per cent and three per cent since last May.

Since October 2023, the inflation rate, excluding interest and rent, has been exactly two per cent—the stated goal of the Bank of Canada. Since the fall, rent and mortgage interest hikes alone have been increasing the overall inflation rate by roughly 40 per cent.

The huge spikes in inflation in 2022 had nothing to do with mortgage interest and rents, but since spring 2023, they’ve become a dominant driver of inflation. The fact that the household sector in Canada is incredibly indebted means that interest rate hikes rapidly become inflation drivers—and the Bank of Canada projects that housing costs will become an even more important driver of inflation throughout 2024 (see chart 3-B).

Governments at all levels are trying to address the housing affordability crisis with more supply, better zoning and even direct cash transfers. These are all necessary and should continue. But building takes time, and cash transfers are a drop in the bucket when faced with a 40 per cent increase in the cost of newly renting an apartment in a single year in cities like Toronto.

The housing affordability crisis is being caused by high interest rates—so the fastest and simplest solution to housing affordability is lower interest rates. Those interest rates are also why inflation isn’t already at two per cent.

It's time to drop interest rates in order to bring down both housing costs and inflation.

Topics addressed in this article

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