Canada’s real estate addiction may limit the central bank’s ability to respond to loosening conditions. The Bank of Canada (BoC) cut its overnight rate by 25 basis points to 2.50% at its September meeting, as expected. Markets are pricing in more cuts, but BMO economists caution that moving too fast risks undoing recent housing market stabilization and reigniting exuberance.
Real and Negative Interest Rates
Before diving into BMO’s warning, it’s important to understand two key financial concepts: real interest rates and negative real rates.
The real interest rate is the inflation-adjusted interest rate—calculated by subtracting inflation from the nominal rate. With the overnight rate at 2.5% and headline inflation at 1.9%, the real rate is 0.6%—barely above zero.
Negative real rates occur when inflation exceeds the nominal rate. Borrowing costs fall below the rate at which money loses value, effectively making debt cheaper over time. Policymakers use this to stimulate borrowing, boost liquidity, and drive demand.
An overlooked question is how inflation is measured. Headline inflation gets the most attention, but it’s volatile. The BoC prefers to minimize volatility by using core inflation measures that were much higher in August: CPI-common (2.5%), CPI-trim (3.0%), and CPI-median (3.1%). By these metrics, the real rate is already at or below zero.
This doesn’t even touch on concerns from banks about recent CPI modeling changes that understate inflation—but that’s a separate issue. What we’re getting at—if inflation happens and it’s not captured in a model, does it exist? But let’s not digress—back to BMO’s warning.
Canada’s Housing Obsession Fueled By Easy Money
The narrative of Canadian real estate’s epic multi-decade price growth is heavily debated. Everything from speculation to immigration has been blamed, and while many of these factors are contributors, only one is required to feed that growth—cheap credit. A point that’s not lost on BMO economists.
“Housing has been a Canadian obsession for at least two decades, with ultra-low rates providing jet fuel to the market since the GFC,” explains BMO Canadian Rates & Macro Strategist Benjamin Reitzes.
Canadian Real Estate Prices Are Hypersensitive To Real Rates
Canadian home prices benefited from plunging rates stimulating borrowing for at least two decades. That went into hyperdrive in 2020 when rates were cut to nearly zero and population growth stalled, but credit was effectively free. Home sales—and prices—plunged as rates rose to healthy levels, despite record population growth.
“A normalization of interest rates has prompted some sanity to return to the market with a decent amount of froth coming out of prices,” explains Reitzes.
He suggests the BoC consider the delicate balance, as cutting too far could reverse this progress—or worse, stimulate excessive market activity and drive speculation.
Bank of Canada Should Draw Line At Negative Rates, Warns BMO
The bank warns policymakers to consider drawing a line at real negative rates, or even nominal rates with a “1-handle.” Slashing rates below this key level is likely to serve as a psychological trigger for buyers and investors.
“A return to negative real rates and/or nominal rates with a 1-handle will likely spark renewed housing exuberance that policymakers… should not want to see,” warns Reitzes, adding that this would run contrary to the cautious tone and government policy goals—well, the stated policy goals.
BMO sees labour market weakness and slowing inflation as justification for easing, but warns that housing risks should limit how far the BoC goes. Both the central bank and policymakers need to weigh the risk of reigniting a bubble. While rate cuts offer short-term relief, they threaten housing stability, future affordability—and ultimately, the economy’s long-term prospects.