House prices can’t climb faster than incomes forever

For the last three years, analysts have been predicting a Canadian housing crash and ensuing recession, yet the economy continues to chug along and house prices are still rising.

However, “house prices can’t climb faster than incomes forever,” said Avery Shenfeld, chief economist at CIBC Capital Markets. Whether plummeting house prices will be the trigger for the next recession or not, it’s likely to be more severe and would take longer to recover from due to today’s high real estate values.

“Today’s high house prices do pose a material risk that, when it comes, the next recession would be longer and deeper than otherwise,” Shenfeld said in a recent note entitled Would We Fear or Cheer a House Price Correction? The note was co-authored by economists Andrew Grantham and Nick Exarhos.

A future recession would be “longer and deeper” because the Bank of Canada’s ability to raise rates to contain growth and inflation is limited due to today’s larger average mortgage principals needed to pay for pricy housing.

“A two per cent rise in mortgage rates would be fairly gentle by past tightening cycles, but would raise monthly payments by roughly 25 per cent on a conventional five-year mortgage,” Shenfeld said, adding that insured mortgages have more of a built-in cushion, which would help keep borrowers solvent.

“It’s going to take a lot less hiking to keep a lid on growth and inflation in the next few years, leaving a lot less room for conventional rate cuts when a recession eventually hits,” he said, adding that QE (quantitative easing) and negative rates “haven’t proven to be as effective as substitutes.”