A new independent staff study from Canada’s central bank aims to help clarify the impact of low rates on housing. Bank of Canada (BoC) researchers found that supply and demand both get a boost with rate cuts. Demand responds almost immediately, but supply follows nearly two years later. If affordability is the goal, monetary policy is the wrong tool, warns the researchers.
BoC Finds Lower Rates Stimulate Demand Faster Than Supply
Central banks lower interest rates to stimulate demand with cheaper short-term financing costs. The mechanics are straightforward: cheaper financing and more leverage help pull purchases forward. Since credit is made faster than supply chains can respond, it creates excess demand. That’s not an accident, it’s the goal—to create non-productive price growth, also called inflation. Housing is one of the best examples of this, as financing and long production times are a part of the industry.
“Demand tends to respond more strongly than supply,” explain staff researchers. They note that cheaper financing stimulates sales quickly, boosting home prices. Strong labour markets amplify this trend, with households less cautious over savings and facing easier lending conditions.
Low rates aren’t the solution to housing affordability that policymakers present. “Monetary policy appears unable to alleviate housing affordability pressures and may instead intensify them when labour market conditions are strong,” they warn.
Supply inevitably responds to low rates. However, builders aren’t just responding to cheaper financing. They’re looking at higher (and more profitable) motivation to build.
Housing Demand Responds Fast, Supply Takes Years
Housing demand responds immediately to cheap credit, but supply takes years. The BoC researchers found resales rise shortly after rate cuts, with the full boost seen 18 to 24 months after. That’s consistent with the BoC’s research on inflation in general. It’s new supply that takes up to two years before it really picks up, according to the research.
“A negative monetary policy shock provides a boost to housing starts beginning around two years after the shock occurs,” explain the researchers.
The rise is due in part to excess demand boosting prices and lowering financing costs. Both boost project viability, creating profit motivation for builders, which takes time to materialize. The delay of roughly two years sounds like a long time, but that’s how long it takes to plan, market, and build new homes.
“The delay of two years is also reasonable as it takes time to plan and get permits for new builds, and this timeline can be especially lengthy for multiple unit buildings,” explains the researchers.
Even The Extra Housing Supply Is Driven By Stronger Demand
Lower rates boost demand immediately and eventually supply. That new supply is the direct result of stronger demand, making it unlikely to fix any imbalances. If supply is responding to demand, the odds of excess supply are virtually non-existent. There is no world where it’s possible to satisfy stimulated demand if supply follows demand.
“Monetary policy is not the most appropriate tool to resolve this imbalance,” they warn.
While outside the scope of the staff paper, this demand-driven cycle also impacts input costs. It’s easy to forget that supply and demand apply to all aspects of the market, not just the finished product. Trying to accommodate excess demand means creating excess demand for inputs. Land, labour, and materials all rise in response to this demand, raising the cost to build new homes. Prices become sticky, as they’re still stuck with the cost of building at higher prices. They become even stickier when policymakers try to absorb these issues and extend inefficiencies.
This isn’t the first time BoC researchers warned low rates don’t fix housing affordability. A few years ago, a then-BoC deputy governor presented research showing lower rates didn’t save buyers money. As it was easier for buyers to absorb higher prices and home prices climbed to absorb the extra slack. Instead of saving money, it boosted home prices and the end users ended up paying a similar amount. Over 20 years of narrative was effectively proven wrong when they looked at the data. The results reflect similar findings from the US Federal Reserve, and CMHC internal chats. Despite the widespread evidence, officials at these organizations rarely publicly acknowledge their findings.
