Bank of Canada quietly updates forecast models to include debt and real estate

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Remember the time the head of Canada’s central bank said the housing bubble was good for the economy? Soak up it, because this might be the last time this happens. the Bank of Canada (BoC) has completed its technical report on the Terms of Trade Economic Model (ToTEM). The model, which is used by the BoC as its main forecasting tool, has now entered its third update in 15 years.

Buried among the formulas in the document is the object of the update – debt and housing. For the first time, the central bank will include household charges in the design and implementation of future monetary policy. Let’s take a 10,000-foot view of the drastic changes they have yet to reveal to the general public.

Terms of Trade Economic Model (ToTEM)

First of all, BoC staff don’t just draw random scribble lines and call them predictions, they use a model. This model is called the Terms of Trade Economic Model (ToTEM). It replaced the Quarterly Projection Model (QPM) used previously.

ToTEM became the main tool used for projections and policy analysis in 2005. The limitations of the model are primarily public criticism of monetary policy. The first ToTEM only looked at the issues from a supply side.

That’s why you think the BoCs fail, when they declare mission accomplished. You’re looking at two different economies, and their version only exists on paper. The latest update seeks to change that by including more nuance of the real world. To fully appreciate the changes made, let’s take a look at how this tool has evolved.

ToTEM I: The Phantom Menace

the first iteration of ToTEM (aka ToTEM I) was not a drastic rewrite of the predictions the QPM cavemen used to make. It was in fact an adoption of the QPM, with a greater ability to predict shocks on the terms of trade. In their own words, the aim was to “focus on the supply of the economy”. It was structured around four areas: consumption, goods and services, capital goods and exports.

Everyone fits into two roles in ToTEM, depending on their wealth and access to credit. The first job is the “income for life” consumer, who goes into debt freely. Lifespan is a reference to the income they earn throughout their life. Since these consumers have access to credit, they can borrow future productivity. This limits their consumption to their access to credit and not to their salary.

This contrasts with the second role, the “current income” consumer. These are borrowers with limited access to credit, more commonly referred to as the poor. Since they do not have access to credit, they usually live paycheck to paycheck. Their budget is directly linked to their disposable income.

If that sounds like oversimplifying consumption, that’s because it is. It also leads to botched solutions for the economy.

ToTEM II: Rise of the credit economy

Sequelae are rarely an improvement, but ToTEM II is a big exception. It was rolled out in 2011, with more realistic factors to improve the model. The main improvements include multiple interest rates, industry demand, as well as investment and housing stocks. The last part was important, as the BoC tried to include the role of household wealth on consumption. It may have resulted in a blinding focus, but we’ll get to that.

In this update, there are three types of consumers – two created from a division of lifetime consumers. Current income consumers retain the same role, with only minor changes. The lifetime income consumer, however, was split in two, unrestricted and restricted.

Unrestricted Lifetime Consumers are people who can borrow and save easily. They can transfer assets and adapt to any economy they face. You probably know these consumers by their catchier name, the rich.

Lifetime consumers are people who can also borrow relatively easily. The difference is that they may not be able to borrow as much as they want. These consumers are more strongly impacted by a change in long-term interest rates. Basically, it’s the middle class.

Current income consumers have remained the same.

ToTEM III: Maybe house prices can have an impact on the economy?

Barely 15 years after the birth of the main forecasting model, they are adding debt. That’s right, ToTEM III focus on debt and house prices. A little over a decade after the Great Recession, which apparently didn’t remind us of debt.

The introduction of household debt adds a fourth consumer, the borrowers. This consumer can access credit in the same way as a lifetime income consumer. However, the BoC says they are different because of “the degree of their impatience.”

In other words, these are people who feverishly consume credit for their lifestyle. Everything is funded, and probably with the belief that they will never need to pay it back. Most likely, this demographic operates on the cost of ownership assumption.

Using indebted households in the mix creates a number of new goals. Specifically, they divide the focus into four key ideas:

  1. Borrowing households are different from saving households. They prefer to consume today, instead of waiting. This removes consumption from subsequent periods of income generation. If it increases demand today, it reduces it later.
  2. Debt service. Since only part of the debt is paid off at a time, it allows people to consume more. The BoC says this means that more attention needs to be paid to the stock and flow of household debt. For those who missed this bookkeeping course, the stock is the dollar amount of debt. Flows are changes in levels, often expressed as rates.
  3. Guaranteed household debt. Yes, Canada’s dependence on using real estate wealth as leverage is now a key factor in the economy. This segment will examine borrowers with two components:
    • Residential mortgage loans. They plan to capture it by taking the investment in housing and multiplying it by the loan-to-value (LTV). This is problematic because bubbles exaggerate LTV ratios. But that’s another discussion for another day.
    • The share of the equity in their current home. They hope to capture the impact of Home Equity Lines of Credit (HELOCs) here. It highlights how dependent people on home equity in Canada are. HELOCs are literally a major economic factor for consumption.
  4. Interest paid on debt. They plan to take into account the interest paid on new loans, as well as the actual interest paid on the debt.

The BoC has just discovered that debt can influence house prices

Like Christopher Columbus discovering the Americas, the BoC discovered that debt contributes to the price of houses. A key improvement to the central bank’s new model is to use more housing data to monitor the economy.

When discussing how the model follows current trends, they cite innovation in housing. The BoC said: “… the main innovation is that borrowers now contribute to aggregate housing demand, allowing mortgage debt and HELOCs to influence prices.” Yes, they called it an innovation.

You know what we’re writing here at Better Dwelling, but the old-fashioned economists say it doesn’t matter? It turns out that the bank’s models were flawed and behavioral dynamics play a role in the value of asset prices. Who would have thought? I mean, other than our regular readers.

The changes may seem small, but they can drastically alter a country’s monetary policy. The central bank of Canada has mainly focused on supply side fixes. He never fully assessed the impact of the request, if at all. The leverage effect on household wealth was not taken into account. No consideration of how asset leverage means greater wealth inequality. No focus on leverage can create demand, raising the price of goods. In a country where most of a household’s wealth comes from debt-induced inflation of assets. Wild.

Developing tools like this takes years, which is why parts of the model were used to evaluate the policy. However, it never played a primary role in forecasting and planning monetary policy. By including housing, the BoC will finally begin to see what many Canadians are facing … instead of a technical document that in no way reflects their reality.

The biggest takeaway is that the Canadian economy is so dependent on debt and housing that it has its own update. Not a small forecast update either. This thing probably took a decade to develop and is the key to the central bank’s plans. If it has such an influence on the economy, measuring it correctly will likely show more risk, very soon.

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