Agathe Côté: Household finances and economic growth
Remarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, at the Canadian Club
of Kingston, Kingston, Ontario, 10 January 2011.
* * *
Introduction
Good afternoon and Happy New Year. Thank you for your invitation to speak to the
Canadian Club. This is my first public speech as a Deputy Governor of the Bank of Canada,
and I am delighted to be delivering it in the historic city of Kingston. In my remarks I will focus
on the state of the Canadian economy, with an emphasis on household finances.
Why does household financial health matter to the Bank of Canada? It matters because how
Canadians spend and how much they spend affect both the conduct of monetary policy and
the stability of the financial system. Sound household finances are vitally important for a
balanced economy.
Collectively, households play a significant role in the functioning of the economy. Household
spending accounts for about 60 per cent of aggregate demand in Canada, and was critical in
lifting the Canadian economy out of the recession. At the same time, however, Canadian
household finances have become increasingly stretched.
Today, I will touch briefly on growing household indebtedness and the risks that it poses to
Canada's financial stability, but my comments will centre mainly on the macroeconomic
outlook and the linkages between household finances and spending. I will start with an
overview of current economic conditions and how the economy evolved during the financial
crisis.
Recovering from the great recession
In mid-2009, the world economy began to emerge from the most severe financial crisis since
the Great Depression. In Canada, the recession lasted for three quarters, from the latter
months of 2008 to mid-2009. Our exports fell dramatically in response to a steep drop in U.S.
demand. Firms cut back on employment; some 417,000 jobs were lost. In response to the
weaker labour market, declines in net worth and increased uncertainty, household spending
also fell. Government spending was the only consistent source of growth throughout this
period.
Despite these challenges, Canada's recovery has been stronger than that of our G-7 peers.
By mid-2010, Canadian output had returned to its pre-recession level and all of the jobs that
had been lost were regained. Since then, almost 46,000 positions have been added.
Canada entered the recession with critically important advantages. Our public debt burden
was the lowest of the G-7 countries. Our monetary policy was highly credible. Our financial
institutions were in good health, owing to the quality of public supervision and private risk
management. Corporate balance sheets were robust. Finally, Canadian household finances
were not as stretched as they were in some other advanced countries. Relative to the
situation in the United States, in particular, the personal savings rate in Canada was higher
and household debt was lower.
These favourable conditions meant that the Bank of Canada could respond aggressively with
substantial monetary easing, while keeping inflation expectations well anchored. They also
allowed governments to roll out extraordinary fiscal stimulus, while maintaining fiscal
sustainability. The fact that our banking system was well capitalized meant that Canadian
banks did not face the same pressures to deleverage, and were able to maintain the supply
of credit, although they did tighten the terms and conditions of lending to businesses.
Because the financial system in Canada was functioning well, the cuts in the policy rate were
transmitted to other interest rates in the economy, and effective borrowing costs for both
households and businesses declined to exceptionally low levels. This helped cushion the
downturn and fuel the recovery in household spending, with the result that consumption
surpassed its pre-recession level as early as the third quarter of 2009. In contrast, business
investment was unusually weak during the recession, and its recovery has been subdued.
In the United States, the situation was, and still is, much worse. Of course, the United States
was the epicentre of the financial crisis. The recovery in the labour market there has been
weak, restraining the growth in labour income. Household balance sheets remain under
pressure from elevated debt levels and the dramatic collapse in home prices. Hence, the
level of consumer expenditures has just recently reached its pre-recession peak and,
following a sharp contraction, the housing market has yet to rebound. Overall, the pace of
recovery in U.S. private domestic demand has been slow. Since the United States is
Canada's largest trading partner, our exports have also been slow to recover. Weak external
demand, combined with the deterioration in Canadian competitiveness in recent years, has
led to sharp contractions in Canada's trade balance and a return to current account deficits.
Thus, despite the advantages I noted a moment ago, Canada's recovery has been relatively
modest in comparison with previous cycles, and has relied heavily on household and
government spending.
Going forward, the Bank expects that the composition of demand will shift away from
government and household spending toward business investment and net exports. In that
regard, the surge in business investment that began last year is an encouraging start. The
strength in net exports will be sensitive to currency movements, the expected recovery in
productivity growth, and the prospects for external demand.
Household finances and spending
From the outlook for the overall Canadian economy, let me now narrow my focus to the
household sector and, in particular, to the links between household spending and household
finances.
As I mentioned at the outset, the resilience in household spending helped propel the
economy out of the recession. A number of factors contributed to the rebound in consumer
expenditures and housing investment, including the recovery in employment and labour
income, the improvement in consumer confidence, and temporary fiscal measures, most
notably the tax credit on home renovations.
Equally important, consumers took advantage of low borrowing costs and, in doing so,
pushed household debt levels to record highs. Since the trough of the recession, household
credit has grown about twice as fast as personal disposable income. By the third quarter of
2010, the debt of Canadian households had reached 148 per cent of disposable income.
In addition to low interest rates, rising house prices and home-equity extractions have played
a role in the growth of credit in recent years and, therefore, have helped to boost household
spending. Why is this? The main channel through which increases in house prices can raise
household spending is called the financial-accelerator effect. When the value of a house
rises, the owner can borrow against the increased equity through a home equity line of credit,
a home equity loan or by simply increasing the size of the mortgage (an option for
homeowners when they renew their mortgage, provided they have sufficient equity). The
funds can be used to finance home renovations, a second house, or other goods and
services. Such expenditures can accelerate the increase in house prices, reinforcing the
growth in collateral values and access to additional borrowing, thus leading to a rise in
household spending. Of course, this accelerator effect can also work in reverse: a decrease
in house prices tends to reduce household borrowing capacity, and amplify the decline in
spending.
Research conducted at the Bank of Canada and elsewhere suggests that the
financialaccelerator effect is economically significant.1 This finding is also consistent with
reducedform evidence of a correlation between consumer spending and housing wealth.2
In the last decade, lending based on housing collateral has risen as a share of total
Canadian household credit. According to Bank of Canada calculations, the volume of
homeequity lines of credit and loans has risen by as much as 170 per cent-or almost twice as fast
as mortgage debt-and now accounts for 12 per cent of the overall stock of household debt.
Since these secured loans are offered at a lower interest rate than unsecured loans,
consumers have used part of the funds to pay down other debts. Microdata suggest that
roughly one-third of the loans are used to that effect, while about 20 per cent are used to
invest in financial assets. The remaining half is spent on current consumption and renovating
or purchasing another property. Over time, there has been a marked increase in the share of
home-equity-backed debt held by older households, an outcome that may not be too
surprising since older households have generally owned their houses longer and have
significant equity in them.3
The overall conclusion based on the microdata and the research is that lower interest rates
for secured lending and increased access to credit as house prices rose have helped fuel net
increases in credit and have supported household spending in Canada in recent years.
Going forward, house price gains are unlikely to provide the same support to household
wealth as they have in recent years. This, combined with the fact that the level of household
debt has reached a record high, leads us to expect that the growth of household
expenditures will slow to a pace closer to that of income.
There are risks, on both the upside and the downside, to the outlook for Canadian household
spending. On the upside, household spending could be stronger than expected if growth in
incomes were to rebound more rapidly than the Bank projects, or if borrowing continues to
exceed income growth. In our projection, we expect slow growth in personal disposable
income owing to the withdrawal of fiscal stimulus, announced compensation restraints by
governments and a slow recovery in average hours worked.
On the downside, if there were a sudden weakening in the Canadian housing sector, it could
have sizable spillover effects on other areas of the economy, such as consumption, given the
high debt loads of some Canadian households. While residential investment declined in the
second half of 2010, it still remains near historically high levels. The Bank expects some
further weakening into 2011, reflecting subdued income growth and declining affordability,
but not a major correction.
1
See M. Iacoviello, "House Prices, Borrowing Constraints and Monetary Policy in the Business Cycle" The
American Economic Review 95, No. 3 (2005): 739-64. See also: M.B. Roi and R. Mendes, "House Prices,
Residential Mortgage Credit and Monetary Policy," Bank of Canada, December 2004 (Available at:
http://www.bankofcanada.ca/en/conference_papers/housing_macroeconomy/roi.pdf); and J. Campbell and
J. F. Cocco, "How Do House Prices Affect Consumption? Evidence from Micro Data," (Harvard Institute of
Economic Research Working Papers No. 2045, 2004)
2
See L. Pichette, "Are Wealth Effects Important for Canada?" Bank of Canada Review (Ottawa, Bank of
Canada, Spring 2004). Available at: http://www.bankofcanada.ca/en/review/spring04/r04-2-ec.html
3
Part of the increase may also reflect the general aging of the population. Microdata indicate that from 1999 to
2009, the share of home equity lines of credit (HELOCs) held by households in the 50-plus age group
increased from 33 per cent to 54 per cent.
BIS central bankers' speeches 3
Household finances and financial stability
Household finances also have important implications for financial stability. While the rapid
expansion of household credit during the recession and the early stages of the recovery is in
part a testament to the resilience of Canada's financial system, it is also a source of risk. As
discussed in the Bank's most recent Financial System Review, the proportion of households
with stretched financial positions that leave them vulnerable to an adverse shock has grown
significantly in recent years.
At an aggregate level, the risk is that a shock to economic conditions could be transmitted to
the broader financial system through a weakening in the credit quality of loans to
households. This could prompt a tightening of credit conditions and, in turn, set off a mutually
reinforcing deterioration of real activity and financial stability.
There are welcome signs of moderation in the pace of debt accumulation, but credit
continues to grow faster than income. Without a significant change in behaviour, the
proportion of households that would be susceptible to serious financial stress from negative
income or wealth shocks will continue to grow.
To better assess the risks associated with growing household indebtedness, the Bank
regularly undertakes stress tests. In the December Financial System Review, we conducted
a partial stress-testing simulation to estimate the impact on household balance sheets of a
hypothetical 3-percentage-point increase in the unemployment rate. The results suggest that
the associated rise in financial stress among households would double the proportion of
loans that are in arrears three months or more.
Even without adverse shocks, household debt-service ratios would be expected to increase
when borrowing costs return to more normal levels. It is the responsibility of households to
ensure that, in the future, they are able to service the debts they take on today. Similarly,
financial institutions are responsible for ensuring that their clients do not take on
unmanageable debt loads.
Policy implications
In response to the global financial crisis and the recession, the Bank of Canada lowered the
target interest rate rapidly over the course of 2008 and early 2009 to its lowest possible level,
and provided exceptional guidance on the future path of rates through its conditional
commitment. These measures delivered considerable stimulus to the economy during a
period of very weak economic conditions. Since last spring, with improvements in the
economy, the Bank has removed the conditional commitment, and raised the overnight rate
from 1⁄4 of one per cent to 1 per cent. This still leaves considerable monetary stimulus in
place, consistent with achieving the 2 per cent inflation target in an environment of significant
excess supply.
Some have asked if increasing interest rates poses such a threat to households, why raise
them? Yet others have asked if household debt is such a concern, why not raise rates and
discourage borrowing?
The cornerstone of the Bank's monetary policy is its inflation-control agreement, the goal of
which is to keep inflation near 2 per cent. In setting interest rates to achieve the inflation
target, developments in household finances need to be weighed along with all the other
factors influencing economic activity and inflation. Canadian monetary policy is set for overall
macroeconomic conditions in Canada.
The Bank recognizes that low interest rates, while necessary to achieve our inflation target,
create their own risks.4 Prudence on the part of individuals and financial institutions is the
first line of defence against these risks. Supervision of financial institutions can also be
effective in limiting excessive concentration of risk. The development and use of selected
macroprudential tools constitute another line of defence.
In the housing market, the federal government has already taken important measures to
address household leverage. These include a more stringent qualifying test that requires all
borrowers to meet the standards for a 5-year fixed-rate mortgage as well as a reduction in
the maximum loan-to-value ratio of refinanced mortgages and a higher minimum down
payment on properties not occupied by the owner. In addition, the Bank of Canada's interest
rate increases reminded households of the interest rate risks they face. These measures are
beginning to have an impact.
As part of our research for the renewal later this year of our inflation-control agreement with
the Government of Canada, the Bank is examining whether there may be cases in the future
where monetary policy should play a supporting role to these other lines of defence by taking
pre-emptive actions against building financial imbalances.5
Conclusion
Sound household finances are a key element of a balanced economy. They are essential to
keep household spending and overall economic growth on a sustainable track and to
maintain the stability of our financial system. This is why the Bank is closely watching
developments in this area.
I hope my comments have provided some additional insight into the Bank's economic outlook
and the determinants of household spending and offer you some guidance about the risks.
The clearer our understanding of the nature of the risks we face, the better able we will be to
make informed decisions to address them. Thank you.