Thank you for this invitation to contribute to this very important work in tackling the question of what to do about inflation. I am here as a private individual and author of three books on finance. I also work as an investment adviser and portfolio manager with one of Canada's largest independent wealth management firms. I'm now in my 43rd year of doing that work.
My first book, called Investment Traps and How to Avoid Them, warned of the stock market bubble in 1999. The second and third publications came out in 2015 and 2018 as first and second editions of the book When the Bubble Bursts: Surviving the Canadian Real Estate Crash. People have noticed that it has been six years since the first edition was released and the housing bubble keeps getting bigger and bigger. Does that mean that the bubble will never burst and my thesis is wrong? I like to explain it this way: I am not going to be wrong about the housing bubble bursting, but I am very early.
I wrote books on housing bubbles because I kept hearing from my clients and others that housing prices will always go up. As an investment professional, I get nervous when people become so certain about an investment, especially one that involves borrowing so much money. Each year, more people were getting themselves and their children heavily invested in housing. By 2010, the housing bubble was well on its way, and since the brief COVID-19 recession in 2020, it has become a full-blown mania probably unsurpassed anywhere in the world.
I see parents and grandparents putting a secure retirement at risk by gifting large down payments to their offspring, co-signing huge mortgage loans and buying second and third properties, often used to provide housing for their children at little or no rent. While this will be fine if house prices never drop, it will be a disaster if we see a crash, as happened in the U.S., Ireland and Spain during the global financial crisis.
The topic today is inflation, not housing bubbles, but there is an important connection between the two. When people say “inflation”, they usually mean the consumer price index. In my research, I found there is a complicated relationship between the CPI and house prices.
House prices in Canada on average have grown at more than 7% per annum over 22 years. This means a fourfold to fivefold increase in total. In dollar terms, a $200,000 house in the year 2000 is now costing about $800,000 to $900,000, and even more in Toronto and Vancouver.
This is obviously inflation, and the CPI considers the cost of housing as its most important component. In the CPI, shelter costs, as housing costs are called, are weighted 31%, but while house prices increased at 7% or more per year, the shelter component of inflation increased by only 2.6% per annum.
It might be a surprise to learn that the CPI does not include house price purchases when calculating inflation. To illustrate this, I distributed a chart to members of the committee that shows seven indexes. It is a very busy chart. The chart shows house prices in Vancouver and Toronto and the Canadian average house price, as well as outstanding household debt. The chart also shows median after-tax income, CPI and shelter costs. All data series are rebased to start at index level 100 in the year 2000.
In 2022, house prices and household debt are all well over 400, with Vancouver over 500, but the shelter cost index has increased to only 175, while CPI and after-tax median income are both just under 200. Therefore, house prices have more than a fourfold increase and shelter costs have less than a twofold increase. If house prices followed the shelter component of CPI, that $800,000 or $900,000 house today would cost only $350,000. Now that would be nice, at least for the first-time buyer.
Instead of house purchase prices, the CPI uses a monthly payment approach to shelter costs. Since the interest cost in the monthly mortgage payment is usually the largest part of shelter costs, when interest rates are low or are pushed lower by central banks, the cost of shelter also remains low. Keeping interest rates low, and therefore the cost of shelter low in the CPI, allowed the central bank to ignore the housing bubble. However, if the Bank of Canada allows mortgage rates to rise above inflation, there will be a sharp increase in the monthly payment, causing the shelter component to rise faster than the CPI.
Before I wrap up my statement, I want to mention one other key issue that connects housing prices and inflation. That is the world-leading burden of private sector debt in Canada. Private sector debt is household debt plus corporate debt, not including the financial sector, usually as a ratio of GDP.
The need to borrow to keep up with house prices has led Canadians into a dangerous place when comparing our private sector debt to that of other countries. Research shows that any country that has a ratio of private sector debt to GDP over 150% and has experienced rapid growth in that ratio will endure a financial crisis eventually. Household debt alone is 110% of GDP. Of course, most of that is mortgage debt. Recently, corporate debt has grown rapidly also, to about 123% of GDP, so total private sector debt at 233% is well above the minimum threshold for a financial crisis.
Raising interest rates with such an elevated burden of private sector debt will be difficult, but inflation must be lowered, even if it means bursting the housing bubble and triggering a recession.
Thank you for your attention, and I look forward to your questions.