Canada’s real estate industry often argues the central bank should ignore shelter inflation and keep rates low to boost supply. A new Bank of Canada (BoC) staff paper tests both claims, and neither holds up as a blanket rule. The researchers find that ignoring shelter inflation during a demand-driven boom is destabilizing to the economy and pushes valuations higher. While rate cuts get more homes built, roughly 80% of that comes from excess demand created by monetary stimulus.

Housing FOMO Makes Ignoring Shelter Inflation Risky

Can the central bank safely ignore shelter inflation? Not when demand is driving it, according to the researchers. “Monetary policy should not look through shelter inflation when it is driven by housing demand shocks. Looking through creates a more volatile economy especially when faced with extrapolative expectations,” they explain.

Extrapolative expectations is a $10 term ($184.70 in 2026 dollars) for assuming a trend will continue. Home prices rise because that’s just what they do—so buyers who believe that load up on more housing and debt during a boom.  

The researchers modelled a boom where home prices climb 20% over two years. Excluding shelter inflation from policy decisions pushes overvaluation as much as 2.2 percentage points higher than a policy that includes it. When buyers have rational expectations, the gap peaks around 1.3 points. In other words, trend-chasing led to a 70% larger overshoot. 

“This amplifies financial stability risks, especially when price dynamics are partly driven by past increases in house prices,” warn the researchers.  

Rate Cuts Are Steroids For Demand, Not A Supply Fix 

Factoring shelter into rate decisions during a boom makes a hike more likely. Higher rates cool demand over time, but they immediately raise financing costs for homebuilders. Cheaper money means more building, argues the industry. In isolation, the math makes sense. Reality is a little more complicated.  

“While financing costs do affect housing supply, supply-side cost effects remain quantitatively secondary to demand-driven mechanisms operating through house prices and expectations,” explain the researchers. 

They modelled a 100 basis point (bp) rate cut, which lifts residential investment 6.2%. Cheaper financing accounted for just 1.4 points of that, roughly 20%. The other 80% injection comes from excess housing demand. Rate cuts technically get more homes built, but primarily by incentivizing more housing consumption.  

Mortgage Interest Makes Rate Cuts Look Like Lower Inflation

After a rate cut, shelter inflation falls for about two years. That drop is mostly mechanical, as Canada includes mortgage interest costs (MIC) in CPI. Cheaper borrowing directly lowers measured shelter inflation, even though the real impact of monetary policy decisions isn’t fully reflected for 18 to 24 months. It’s a problem most countries avoid, including the United States. 

Since CPI drives rate decisions and rates drive mortgage interest costs, mortgage interest creates a feedback loop. Rates fall, mortgage interest falls, measured inflation falls, and the BoC cuts rates to lift inflation back to target. The researchers call it a “policy amplification loop,” where easing reinforces the housing boom. It makes the case for ignoring mortgage interest, even as they warn against ignoring demand-driven shelter inflation.  

We’ve covered this problem in depth before, so it’s nice to see it get some time in the monetary policy spotlight. 

Hiking Rates Into A Supply Shock Slows Output, Not Inflation

When a supply crunch is driving shelter inflation, hiking rates barely makes a dent. Higher rates raise mortgage interest costs, offsetting much of the cooling in home prices. 

Rents rise too. In the model, rental returns have to compete with what investors could earn on financial assets, so higher rates push rents up. 

Responding to shelter with hikes “does little to reduce cumulative shelter inflation,” note the researchers. Total headline inflation ends up nearly identical whether the BoC reacts to shelter or not, according to the model. Economic output is a different story.  

“In contrast, reacting to the housing supply shock leads to a significantly larger decline in output. This trade-off suggests that looking through housing supply shocks may be welfare-enhancing,” the researchers conclude. 

Even the case for looking through shelter inflation comes with a caveat. They warn that if the supply shock persists, the risk of de-anchoring inflation expectations rises, urging caution. 

What The Bank of Canada’s Model Misses About Rates & Productivity

The researchers are clear: the BoC can’t safely ignore shelter inflation when demand is driving it, and rate cuts aren’t a supply strategy. Hikes restrain home prices even in a shortage, but measured shelter inflation barely moves, since higher mortgage interest costs and rents offset the cooling. 

What the model doesn’t show is the cost to the rest of the economy. The study shows a 100 bp rate cut lifts residential investment 6.2%, dwarfing the boost to output and business investment. In this scenario of a housing demand shock, residential investment growth significantly outpaces the boost to business investment and economic output. The model treats this as a passing problem: one shock, and everything returns to normal within five years. That’s not reality.

The BoC doesn’t cut rates once, then take a decade off. Repeated easing has pushed residential investment’s growth past the rest of the economy, concentrating capital in housing. The model has no way for business investment to lift future productivity, the exact problem that policymakers are currently struggling with. It can’t count what’s lost when that capital is diverted from other industries, nor does it measure whether, when or how it returns. The paper shows where the stimulus goes. It just doesn’t capture the full cost.