Remember that time the head of Canada’s central bank said the housing bubble was good for the economy? Soak it up, because that may be the last time it ever happens. The Bank of Canada (BoC) finished its technical report on the Terms-of-Trade Economic Model (ToTEM). The model, which is used by the BoC as their primary forecasting tool, has now entered its third update in 15 years.
Buried amongst the document’s formulas is the focus of the update — debt and housing. For the first time ever, the central bank will include household burdens in the design and implementation of future monetary policy. Let’s take a 10,000 ft view of the drastic changes they have yet to reveal to the general public.
Terms-of-Trade Economic Model (ToTEM)
First, BoC staff doesn’t just draw random scribble lines and call them forecasts, they use a model. That model is called the Terms-of-Trade Economic Model (ToTEM). It replaced the quarterly projection model (QPM) used prior.
ToTEM became the main tool used for projections and policy analysis in 2005. The limits of the model are basically the public’s criticism of monetary policy. The first ToTEM only looked at problems from a supply-side perspective.
That’s why you think the BoC is failing, when they declare mission accomplished. You’re looking at two different economies, and their version only exists on paper. The newest update seeks to change that by including more real-world nuances. To fully appreciate the changes being made, let’s look at how this tool evolved.
ToTEM I: The Phantom Menace
The first iteration of ToTEM (aka ToTEM I) wasn’t a radical rewrite of the QPM cave people used to forecast. It was actually an adoption of the QPM, with a greater ability to forecast terms-of-trade shock. In their own words, the goal was to place “an emphasis on the economy’s supply side.” It was based on four areas: consumption, goods and services, investment goods, and exports.
Everyone fits into two roles in ToTEM, according to their wealth and access to credit. The first gig is the “lifetime income” consumer, who borrows debt freely. Lifetime is a reference to the income they earn throughout their life. Since these consumers have access to credit, they can borrow future productivity. That makes their consumption limited to their access to credit, not their wages.
This is in contrast to the second role, the “current income” consumer. These are borrowers with limited access to credit, more commonly known as poor people. Since they don’t have access to credit, they generally live paycheque-to-paycheque. Their budget is directly linked to their disposable income.
If it sounds like an oversimplification of consumption, that’s because it is. It also leads to sloppy fixes for the economy.
ToTEM II: Rise of The Credit Economy
Sequels are rarely an improvement, but ToTEM II is one big exception. It was rolled out in 2011, with some more realistic factors to improve the model. Key improvements include multiple interest rates, sector-specific demand, and housing investment and inventories. The last part was big, as the BoC tried to include the role of household wealth on consumption. That may have resulted in a blinding focus, but we’ll come back to that.
In this update, there are three types of consumers — two created from a split of lifetime consumers. Current income consumers remain in the same role, with only minor changes. The lifetime income consumer was split in two though, unrestricted and restricted.
Unrestricted lifetime consumers are people that can borrow and save with ease. They can shift assets, and accommodate whatever economy they face. You probably know these consumers by their catchier name, the rich.
Restricted lifetime consumers are people who can borrow with relative ease as well. The difference is they may not be able to borrow as much as they want. These consumers are more heavily impacted by a shift in long-term interest rates. Basically, this is the middle class.
Current-income consumers stayed the same.
ToTEM III: Maybe Home Prices Can Impact An Economy?
Just 15 years after the primary forecasting model was born, they’re adding indebtedness. That’s right, ToTEM III will include a focus on indebtedness and home prices. Just over a decade after the Great Recession, which apparently didn’t make us think of debt.
The introduction of household indebtedness adds a fourth consumer, borrowers. This consumer can access credit the same way as a lifetime income consumer. However, the BoC says they’re different due to the “degree of their impatience.”
In other words, these are people who consume credit feverishly for their lifestyle. Everything is financed, and likely with the belief, they’ll never need to pay it off. Most likely this demographic operates on the assumption of carrying costs.
Using debt-driven households in the mix creates a number of new focuses. More specifically, they break down the focus into four key insights:
- Borrower households are different from saver households. They have a preference to consume today, instead of waiting. This pulls consumption out of later income-earning periods. While it increases demand today, it reduces it later.
- Debt service. Since only a portion of the debt is paid off at a time, this allows people to consume more. The BoC says this means a greater focus needs to be put on the stock and flow of household debt. For those that missed that accounting class, stock is the amount of debt in dollar terms. Flows are the changes in levels, often expressed as a rate.
- Collateralized household debt. Yup, Canada’s addiction to using housing wealth as leverage is now a key factor in the economy. This segment will look at borrowers with two components:
- Residential mortgages. They plan on capturing it by taking housing investment, and multiplying it by the loan-to-value (LTV). This is problematic since bubbles exaggerate LTV ratios. But that’s another discussion for another day.
- The share of their current home equity. They’re hoping to capture the impact of home equity lines of credit (HELOC) here. It highlights how dependent people are on home equity in Canada. HELOCs are literally a major economic factor for consumption.
- Interest paid on debt. They plan on factoring in the interest paid on new loans, as well as the effective interest paid on debt.
The BoC Just Discovered Debt Can Influence Home Prices
Like Christopher Columbus discovering the Americas, the BoC has found debt contributes to home prices. A key improvement in the central bank’s new model is using more housing data to monitor the economy.
When discussing how the model keeps up with current trends, they cite innovation in housing. The BoC said, “… the main innovation is that borrowers now contribute to overall housing demand, allowing mortgage debt and HELOCs to influence prices.” Yup, they called it an innovation.
You know the stuff we write about here at Better Dwelling, but old-timey economists say it doesn’t matter? It turns out the bank’s models were wrong, and the dynamics of behavior do play a role in the value of asset prices. Who would have thought? I mean, other than our regular readers.
The changes may not seem like a big deal, but they can drastically alter the country’s monetary policy. Canada’s central bank focused largely on supply-side fixes. It never fully assessed the impact of demand, if at all. There was no consideration of how leverage impacts household wealth. No consideration of how the leverage on assets means greater wealth inequality. No focus on leverage can create demand, increasing the price of goods. In a country where most of a household’s wealth comes from debt-driven asset inflation. Wild.
Developing tools like this takes years, so parts of the model have been used to assess policy. However, it’s never played a primary role in forecasting and planning monetary policy. By including housing, the BoC will finally start to see what many Canadians face… instead of a technical document that in no way reflects their reality.
The biggest takeaway is the Canadian economy is so dependent on debt and housing, it got its own update. Not a small forecasting update either. This thing likely took a decade to develop, and is key to central bank plans. If it presents that much of an influence on the economy, measuring it properly will likely show more risk, real soon.
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