First Out of the Gate: Is the Adjustment by the Bank of Canada Justified?

In a bold move Tuesday, the Bank of Canada raised its overnight lending rate by a quarter percent to 0.5%. Canada becomes the first of the G7 nations to raise interest rates after the fallout of 2008. Even among the uncertainty of the European debt crisis, the BP oil spill, and the potential outbreak of war in the East, the BoC's Mark Carney firmly decided to raise the lending rate to banks across Canada. The recent move doesn't seem to make much sense considering the current economic scene but this is a time when it doesn't hurt to be safe rather than sorry.

The Canadian economy has done comparatively well amongst other developed nations worldwide and the first quarter results have Canada on track to grow GDP by 6.1% in 2010. Canada has greatly benefited from the gains made in the commodity markets and the boom in construction and infrastructure. Not to mention, the financial crisis was well contained in Canada as the Canadian banks showed strength with more conservative positions in consumer lending and derivatives trading. Considering all that has gone well for Canada so far, I find it not too surprising that the BoC has decided to (even modestly) raise rates.

While the rate hike is still very conservative, it is a good stepping stone for future increases if needed. With the current state of the economy, there is reasonable concern for the possibility of bubbles arising or the risk of inflation. As of right now, two issues should be of critical concern to the BoC: the housing market and the growing consumer debt load. As a resident of Ontario, I have seen both of these growing trends first hand.

Firstly, the housing market, especially in Toronto, has seen quite the boom. While there is no way to be certain, I question whether property value appreciation is legitimate or rather, based on speculation that there will continue to be an insatiable demand for homes and condos in Toronto. Aside from my nature to be critical, there does seem to be at least a few reasons why Toronto could be experiencing a partial real estate bubble. As it stands currently, real estate in Toronto is deemed to be overvalued by approximately 10-14% and the average value of a home in Toronto is now above $425,000. Note: this situation is even more intensified in Vancouver, BC. What's important about this figure is that while homes have been increasing in price, real income has been rather stagnant. If income cannot keep up with increased housing prices, affordability will drop off and this could ultimately stagnate the Toronto real estate market.

Along with the current rise in home prices, there is intense competition among condo developers to build condominiums on the corner of nearly every major block. Driving through Toronto, you can see the wide array of new condominiums currently being constructed, all looking to be complete within the same 2-year time span. With this ever increasing supply of housing space, I can't help but to think that supply will eventually outweigh demand, especially now that demand is likely to fall with the HST in effect starting July 1st and mortgage rates only coasting higher from here. Considering the above, I see two viable outcomes. 1) The condominium market will be high in demand and people will flock from their homes to downtown condominiums. This will cause housing prices to take much needed correction and go down to more realistic prices. 2) There may eventually be an oversupply of condos which could lead to a price correction in the condo market. Of the two scenarios, I am leaning more towards the second.

The other issue of great importance for the BoC is the growing consumer debt load. While right now it is not near the astronomical levels reached in the United States, it has still increased modestly for the past year. The problem with an overload of consumer debt is that it can quickly grow out of control and give a false sense of "growth" in the economy. This is why it is important that the BoC keep a close eye on the relevant statistics going forward to make sure interest rates are hiked if household debt continues to climb.

With the recent upward tick in the interest rate, the BoC stands in good position to deal with any overheating within the Canadian economy. I hope that going forward, the BoC makes the tough decisions to continue raising rates, even in lieu of the slowly recovering global economy. The time has never been better for Canada to become more economically independent and less exposed to the potential of another global recession. As a Canadian, I am proud of our results coming out of this recession. Even with our success though, it is critical to keep focused; for the most important economic decisions have yet to come.

- The Watchdog