Canada’s central bank will be watching home prices carefully when setting interest rates. In a note to investors, BMO Capital Markets explained that falling new home prices reduced the consumer price index (CPI) readings. However, they’re starting to bottom and are likely to become an influence on higher inflation. The Bank of Canada (BoC) is expected to keep a close eye on home prices, as they turn into an inflationary risk.
Shelter is the largest cost Canadians face, and therefore has the biggest influence on the CPI. Shelter is the largest major component, representing 28.34% of the CPI basket. Rents (6.79% of the basket), and homeowner replacement costs (5.47%) are the largest subcomponents, and can drive big swings. We all know that soaring rents have been a big contributor to inflation, you might be less familiar with homeowner replacement costs.
Replacement costs are often used in the insurance industry. It’s the cost of replacing something at the current price. In the case of a house, it might have been built for a nickel in the 60s, but replacing it would reflect current building costs. To determine this, Stat Can refers to new home prices, which is where BMO sees rising inflationary concerns brewing. Put a pin in this, because there’s a quick point that needs to be clarified about inflation.
Canada Adopted A Model That Will Chronically Understate Inflation
Canada’s recent changes to its CPI methodology will chronically underreport inflation (further). The shift involves annual changes to the basket, making it much more volatile. There’s a reason they don’t adjust Census boundaries annually—short-term fluctuations happen, and adjusting them immediately can be problematic. Imagine cutting school funding if two families move out of a neighborhood, only to see two more come in a year later?
The price of most goods can fluctuate that rapidly too, with a big surge followed by a pullback. By adjusting the basket annually, contributions to inflation will be understated, and contributions to deflation will be overstated. It’s a problem Canada’s major banks have shared. It’s a problem our staff was invited to discuss with Stat Can. They see why the issue is a concern with Census, but not things like shelter.
The impact on shelter has been wild to say the least. While Canadians struggle with higher and higher shelter costs, both owners and renters—the basket weight shrank. In 2020, shelter represented 30% of the basket. Last year’s brief decline in home prices, which only a small share of people realized, resulted in trimming nearly two points from the basket. Keep that in mind while you read the rest.
Falling New Home Prices Are Helping To Reduce Inflation
New home prices in Canada surged in the early 2020s, driving inflation higher via homeowner replacement costs. Helped by the overstated inflation issue, the pullback that followed after rate increases helped bring CPI lower. That momentum, helped by a base effect, is expected to continue contributing to lower inflation in the near-term.
“New home prices continued their disinflationary march in July, pointing to further cooling in this component of shelter costs for the August CPI report,” explains BMO economist Shelly Kaushik.
Adding, “Momentum slowed quickly as the Bank of Canada started raising rates in 2022, with base effects bringing annual growth into negative territory for the past four months.”
Source: BMO Capital Markets.
New Home Prices May Resume Their Climb, Pushing Inflation Higher
Looking at the above chart, you can see Kaushik’s concern. The year-over-year negative growth is beginning to bottom. Once it gets back above zero, it will resume its contribution to higher CPI, and reinforcing higher interest rates. It can even cause rates to climb further, depending on how much growth it experiences.
“While past monetary tightening will continue to weigh on the housing market in the coming months, the correction looks to have bottomed out. Positive monthly moves in the NHPI suggest it could start adding to inflation again,” says Kaushik.
Observers of interest rates should keep an eye on the cost of shelter in the coming months. “Looking ahead, the direction of shelter costs will be a major factor in broader CPI inflation, so the Bank will keep a close eye on house prices as it weighs its decisions for the rest of the year,” she warns.