Canada’s inflation rate came in above expectations last week, rising to its highest level in more than a decade.

If above-target inflation persists, it could have ramifications for homeowners in the form of shifting rate-hike expectations.

Canada’s inflation rate came in burning hot at 3.7% for July, according to data released by Statistics Canada. That’s the third consecutive monthly inflation reading that has come in above the Bank of Canada’s neutral range of 1.75% to 2.75%, which is the range needed to support the economy at full employment/maximum output while keeping inflation under control.

But the Bank of Canada continues to believe that elevated consumer prices will prove temporary and are largely the result of an economy recovering from the pandemic-induced slump.

“…inflation is likely to remain above 3% through the second half of this year and ease back toward 2% in 2022, as short-run imbalances diminish and the considerable overall slack in the economy pulls inflation lower,” the Bank said following last month’s interest rate decision. “The factors pushing up inflation are transitory, but their persistence and magnitude are uncertain and will be monitored closely.”

More recently, Bank of Canada Governor Tiff Macklem reaffirmed the messaging that everything is under control in a July 29 Financial Post column. “The Bank of Canada remains firmly committed to keeping inflation low, stable and predictable,” he wrote. “Even with the gyrations caused by the pandemic, inflation has averaged pretty close to target through the past few years to today. You can be confident that we will keep the cost of living under control as the economy reopens.”

But the central bank can only allow high inflation to persist for so long before a policy response is required.

“The Bank of Canada may be willing to tolerate higher inflation while the economy is still re-opening and recovering from the health shock, but it will respond to more lasting price pressures by reducing monetary accommodation,” wrote TD Bank senior economist James Marple in a recent post. “In the near-term, asset purchases are likely to continue to be pared back, with rate hikes likely to follow late next year.”

At the Bank’s last rate decision meeting in July, it announced that it was reducing its bond-buying program to $2 billion per week from $3 billion.

At the height of the pandemic, the BoC embarked on a quantitative easing program in which it purchased at least $5 billion worth of bonds each week to flood the market with liquidity, in turn keeping 5-year bond yields—and by extension, 5-year fixed mortgage rates—lower than they otherwise would be.

Average mortgage rates remain slightly above their all-time lows reached in December. But the question is, for how much longer?

The Timing of Future Rate Hikes

Those concerned about imminent rate hikes can take solace in the Bank of Canada’s repeated forecast that rates won’t increase until the second half of next year.

“We remain committed to holding the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2% inflation target is sustainably achieved. In the Bank’s July projection, this happens sometime in the second half of 2022,” read the BoC’s statement from its July rate meeting.

The bond market’s read on future rate hikes is that consumers can expect one quarter-point rate hike over the next year, which would take the BoC’s overnight lending rate from its current record low of 0.25% to 0.50%.

And despite the latest high inflation figures, the bond market is actually forecasting one less rate hike over the next two years compared to a couple of months ago—it now expects three 25-bps hikes over the next two years, down from four. Looking three years out, the Bank of Canada is expected to deliver five quarter-point rate hikes in total, bringing the overnight rate to 1.50%.

This would cause prime rate to increase, leading to higher monthly payments for many borrowers with variable-rate mortgages. For those with fixed-payment variable mortgages, the amount of their payment going towards paying down the principal will decline, and the amount going towards interest will increase.

If prime rate was to rise 125 basis points over the next three years, the average mortgage payment could increase by approximately $180 a month, or $2,172 a year, based on today’s average mortgage amount and the lowest variable rates available nationally.

Borrowers with fixed-rate mortgages would not be immediately impacted by rising rates until their mortgage comes up for renewal at the end of their term, or unless they choose to refinance.

“While we are not overly concerned of a payment shock for renewals, the increase in mortgage rates will certainly impact purchasing power for many,” economists from National Bank of Canada wrote in a recent note.

Long-awaited tweaks to the government’s First-Time Home Buyer Incentive came into effect on Monday.

Nearly five months after the changes were first proposed, the Department of Finance and Canada Mortgage and Housing Corporation (CMHC) have enhanced the eligibility criteria for buyers in Toronto, Vancouver and Victoria.

As a recap, the FTHBI is a shared-equity program whereby the government contributes between 5% and 10% of a first-time buyer’s down payment, and shares in any increase or decrease in the home value until the loan is repaid. The buyer doesn’t need to make any monthly payments, though the loan must be repaid after 25 years or when the home is sold.

The new eligibility requirements include:

• the maximum eligible household income has been raised to $150,000 (an increase from $120,000)
• participants can borrow up to 4.5 times their household income, up from the current four times.

The changes are limited to those living in the three cities noted above, while the original criteria continue to apply to those living in the rest of the country.

“Our government recognizes that making the choice to own for the first time is a challenge, especially in major markets where housing costs are rising fastest,” said Adam Vaughan, Parliamentary Secretary to the Minister of Families, Children and Social Development and the Minister responsible for the CMHC. “To that end, the new enhancements under the Incentive increases the eligibility of the program in Toronto, Vancouver and Victoria.”

What do the FTHBI changes mean?

The increase in the maximum household income and borrowing limit means first-time buyers wanting to participate in the program can now theoretically qualify for a purchase price up to $722,000, up from roughly $505,000 for those under the original requirements.

This comes at a time when the average house price has soared to $716,000, according to March data from the Canadian Real Estate Association. Even without the high-priced markets of the Greater Toronto and Vancouver areas, the national average price still stands at $556,828.

The question, of course, is whether the changes will actually assist first-time buyers struggling with affordability as prices continue to rise nationwide.

“No. The program isn’t really assistive to first-time buyers,” says Paul Taylor, President and CEO of Mortgage Professionals Canada. “Even with the increased 4.5 times income, all eligible participants would actually be able to borrow more using a traditional 5% down insured mortgage. As such, it won’t really create any new market entrants. It will provide an option for those who already qualify, in very specific parameters, to reduce their monthly payments at the tradeoff of home equity.”

Taylor told CMT that the program is true to its name, being an “incentive” program as opposed to being “assistive.”

“The government is incentivizing first-time buyers to take on less debt and to reduce their monthly payments, but the tradeoff is reduced purchasing capacity and government co-ownership,” he added, saying the number of borrowers eligible to actually qualify for the new maximum purchase price of $722,000 “will be very small.”

While Canada’s economy recorded its largest-ever annual GDP drop of 5.1% last year, it’s also on track to post a comeback in Q4, which could force the Bank of Canada’s hand in reining inflation in sooner than anticipated.

“That carries potentially strong policy implications for the Bank of Canada that is increasingly looking as if it over-committed itself to keeping rates on hold until 2023,” wrote Scotiabank economist Derek Holt in a recent research note.

While GDP data isn’t out for December yet, the fourth quarter is on track to post a gain of 7.8%, according to estimates.

Holt added that based on preliminary Q4 data, the first quarter now has roughly 1.7% annualized GDP “baked” into it. That would be in stark contrast to the 2.5% contraction forecast by the Bank of Canada in its January Monetary Policy Report.

Additionally, some say the federal government’s talk of up to $100 billion in new stimulus spending over the next three years could contribute to over-stimulating demand.

“A key risk is that the proposed $70-100 (billion) in three-year stimulus funds will outlive their need, at least when it comes to boosting demand after 2021,” wrote CIBC economist Avery Shenfeld.

Implications for interest rates

All of this translates into the potential for the need to raise interest rates earlier than the 2023 timeframe that has been repeated in BoC messaging in recent months.

“If Canada’s economy outperformed expectations without vaccines, then just imagine how it might perform as herd immunity approaches by fall and what that may come to mean for monetary policy,” Holt added.

“With average core inflation trending around the 1.6–1.7% range and just tenths beneath the 2% target, the BoC might wind up on its inflation target or above it and sooner than it thinks.”

Shenfeld drew the same conclusion, saying that if enough demand is added post-2021, and the economy could close in on full employment, “with additional government spending being offset by an earlier need to hike interest rates to contain inflation.”

What Should Borrowers be Thinking About?

Holt’s advice to those who are heavily indebted is to plan their finances on the basis of the BoC starting to hike rates “considerably sooner” than 2023.

“If slack is eliminated into next year and inflation returns closer to target, then there should be little compelling reason for why the BoC would still be sitting on such emergency levels of stimulus if the emergency has long passed,” he wrote.

This may also give new homebuyers reason for pause if they’re considering getting a variable mortgage rate. With variable-rate mortgages priced as little as 30 basis points below certain fixed-rate mortgages, it could take just one Bank of Canada rate hike for that edge to all but disappear.

For that reason, many have already been choosing the security of today’s historically low fixed rates.

But they too could start to rise in short order at the first sign that a recovery is taking hold.

“If the BoC believes that our economic recovery has reached a more sustainable footing, it will begin to taper its (Quantitative Easing) purchases (of bonds), and when that happens, it is expected that our government bond yields, and the fixed mortgage rates that are priced on them, will rise in response,” wrote Dave Larock of Integrated Mortgage Planners Inc.

“While it may not be intuitive at first glance, changes in the BoC’s outlook are therefore likely to impact our fixed mortgage rates well before they impact our variable rates.”