Is Poloz willing to sacrifice housing and free enterprise with negative rates?

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Updated - includes link to Roundhouse Radio interview

The foundation of a free market is a unfettered price of money: the interest rate that borrowers are willing to pay savers to complete a transaction. In a true free market, this is determined by the interaction between the borrowers and lenders. However, a free market in short-term rates has not existed since the introduction of modern central banking which, through legislation, gives these institutions the power to set overnight rates. More recently, the world's major central banks have been surprisingly successful at manipulating longer-dated interest rates through massive asset purchases or "QE."

Now it turns out that just as the bulk of North American baby boomers start heading or preparing for retirement, the chickens of decades of central bank intervention have come home to roost. In 2008, we had the great financial crisis followed by a successive series of asset bubbles around the world. While in Canada our financial system appeared unscathed compared to the United States (which required direct tax payer bailouts), our banking system was given a big helping hand from the Harper government by CMHC assuming the risk associated with billions in mortgage liabilities. At the time, the move went relatively unnoticed. As it turns out, that intervention became part of a trend that has morphed into a potential mortgage time bomb that could be triggered by a number of scenarios, the most dangerous being a combination of a slowing economy and rising rates.

Canadian Finance Minister Bill Morneau

To his credit, Bill Morneau has decided to try and defuse the ticking CMHC mortgage time bomb by introducing several changes to mortgage insurance rules. The cornerstone of his new policy is testing borrowers of insurable mortgages at a "posted rate" as opposed to a lower "best rate" that is usually available in the market.

These moves will start to have an effect over a number of years and are likely to force some less creditworthy borrowers to assume more modest levels of debt. In some cases, they will have to save more and wait before getting approved. Essentially, Morneau is being more pro-market as it reduces, but does not eliminate, the generous taxpayer mortgage risk subsidy.

Has Bill Morneau defused the CMHC debt bomb?

There is one big problem. Bill Morneau on Monday renewed the Bank of Canada's inflation-targeting framework to guide its monetary policy. The mandate seeks to achieve Consumer Price Index (CPI) inflation at a level of close to 2% and remaining in a range of between 1% and 3%. While that sounds good enough, it is under this same framework that housing prices exploded in Vancouver and are now at "red alert" status across the country according to CMHC. 

A fatal flaw in CPI targeting is its failure to capture the true cost of housing. The CPI might as well be called the Chairs and iPads Index because those are the types of things it measures. Meanwhile, instead of measuring actual housing prices, it looks at things like mortgage and maintenance costs. That focus on gadgets instead of housing gave central bank Governor Stephen Poloz every excuse he needed to loosen monetary conditions ahead of the last election, even as crude oil prices were soaring and housing prices in Vancouver were flying. His rationale was that by making our exports of chairs, car parts, and cranberries more competitive via a cheaper loonie, the central bank would have more confidence that some sort of sustainable CPI inflation rate at 2% was attainable.

This was little more than spin to help boost the price-sensitive export sector at just about everyone else's expense. I should emphasize that not every export-oriented company is a price-sensitive exporter. Many exporters compete on the basis of design, proprietary know-how and innovation. A low and volatile loonie is of no help to these exporters, a group which the Bank of Canada by its own admission knows little about.

The collateral damage from the Bank of Canada's loose money approach has been substantial. Money flooded into the oil patch on the back of a weakening loonie even as crude was in the process of peaking in 2013 and early 2014. The subsequent collapse has been devastating. Now, after years of money flowing into the residential real estate sector, there is real danger of some serious financial carnage. If we are lucky, we will avoid the fate of the United States in 2008. However, Canadians should not kid themselves, we will need luck on our side.

The fact that inflation has generally remained within the 1% to 3% range has not deterred the emergency rate posture of the central bank that clearly favours price-taking exporters over the Canadian poor who must spend significant portions of their incomes on imported food. Alarmingly, Stephen Poloz has now embraced the potential use of negative interest rates and asset purchases to further drive down the loonie if he deems it necessary to give a further boost to exports.

Call me skeptical, but it won't work. For Canada to succeed at the export game, it will be based on human capital, not brawn slugging it out with developing nations in a race to the bottom in terms of price. Instead, negative interest rates would likely invigorate speculative demand for housing right across the country. Keep in mind that under a negative rate policy, not everyone gets the special deal. Only those borrowers who are positioned up the credit ladder will get paid to borrow money. Indeed, preferred borrowers will likely get a lion's share of the credit available in a negative rate economy. While this is not a prediction, I can foresee a scenario where some ordinary Canadians could be shaken out of their homes in the wake of an initial housing pullback, only to see prices race higher as negative rates are introduced.

Negative rates would also destabilize free enterprise by tilting the scales heavily in favour of those with preferred access to credit. Firms, typically large ones, who can get access to negative rates and get paid to borrow could end up crushing small company competitors or even same-size competitors with lower credit worthiness. It would mark a return to an aristocracy - in this case, a credit aristocracy.

Unfortunately, for the next 5 years central bank Governor Stephen Poloz will be able use CPI targeting as an excuse to potentially adopt negative rates. In the process, not only will housing hyperinflation risk be back on the front burner, but free enterprise where merit trumps privilege would be under siege. At that point, Canada will have created the landscape for its very own lost generation.

I discussed the implications of negative rates for the Canadian economy including real estate in my weekly economic commentary and discussion with Kirk Lapointe on Roundhouse Radio Thursday evening. Listen to the replay here.

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