Remember that time the head of Canada’s central bank said the housing bubble was good for the economy? Soak it up, because that may be the last time it ever happens. The Bank of Canada (BoC) finished its technical report on the Terms-of-Trade Economic Model (ToTEM). The model, which is used by the BoC as their primary forecasting tool, has now entered its third update in 15 years.
Buried amongst the document’s formulas is the focus of the update — debt and housing. For the first time ever, the central bank will include household burdens in the design and implementation of future monetary policy. Let’s take a 10,000 ft view of the drastic changes they have yet to reveal to the general public.
Terms-of-Trade Economic Model (ToTEM)
First, BoC staff doesn’t just draw random scribble lines and call them forecasts, they use a model. That model is called the Terms-of-Trade Economic Model (ToTEM). It replaced the quarterly projection model (QPM) used prior.
ToTEM became the main tool used for projections and policy analysis in 2005. The limits of the model are basically the public’s criticism of monetary policy. The first ToTEM only looked at problems from a supply-side perspective.
That’s why you think the BoC is failing, when they declare mission accomplished. You’re looking at two different economies, and their version only exists on paper. The newest update seeks to change that by including more real-world nuances. To fully appreciate the changes being made, let’s look at how this tool evolved.
ToTEM I: The Phantom Menace
The first iteration of ToTEM (aka ToTEM I) wasn’t a radical rewrite of the QPM cave people used to forecast. It was actually an adoption of the QPM, with a greater ability to forecast terms-of-trade shock. In their own words, the goal was to place “an emphasis on the economy’s supply side.” It was based on four areas: consumption, goods and services, investment goods, and exports.
Everyone fits into two roles in ToTEM, according to their wealth and access to credit. The first gig is the “lifetime income” consumer, who borrows debt freely. Lifetime is a reference to the income they earn throughout their life. Since these consumers have access to credit, they can borrow future productivity. That makes their consumption limited to their access to credit, not their wages.
This is in contrast to the second role, the “current income” consumer. These are borrowers with limited access to credit, more commonly known as poor people. Since they don’t have access to credit, they generally live paycheque-to-paycheque. Their budget is directly linked to their disposable income.
If it sounds like an oversimplification of consumption, that’s because it is. It also leads to sloppy fixes for the economy.
ToTEM II: Rise of The Credit Economy
Sequels are rarely an improvement, but ToTEM II is one big exception. It was rolled out in 2011, with some more realistic factors to improve the model. Key improvements include multiple interest rates, sector-specific demand, and housing investment and inventories. The last part was big, as the BoC tried to include the role of household wealth on consumption. That may have resulted in a blinding focus, but we’ll come back to that.
In this update, there are three types of consumers — two created from a split of lifetime consumers. Current income consumers remain in the same role, with only minor changes. The lifetime income consumer was split in two though, unrestricted and restricted.
Unrestricted lifetime consumers are people that can borrow and save with ease. They can shift assets, and accommodate whatever economy they face. You probably know these consumers by their catchier name, the rich.
Restricted lifetime consumers are people who can borrow with relative ease as well. The difference is they may not be able to borrow as much as they want. These consumers are more heavily impacted by a shift in long-term interest rates. Basically, this is the middle class.
Current-income consumers stayed the same.
ToTEM III: Maybe Home Prices Can Impact An Economy?
Just 15 years after the primary forecasting model was born, they’re adding indebtedness. That’s right, ToTEM III will include a focus on indebtedness and home prices. Just over a decade after the Great Recession, which apparently didn’t make us think of debt.
The introduction of household indebtedness adds a fourth consumer, borrowers. This consumer can access credit the same way as a lifetime income consumer. However, the BoC says they’re different due to the “degree of their impatience.”
In other words, these are people who consume credit feverishly for their lifestyle. Everything is financed, and likely with the belief, they’ll never need to pay it off. Most likely this demographic operates on the assumption of carrying costs.
Using debt-driven households in the mix creates a number of new focuses. More specifically, they break down the focus into four key insights:
- Borrower households are different from saver households. They have a preference to consume today, instead of waiting. This pulls consumption out of later income-earning periods. While it increases demand today, it reduces it later.
- Debt service. Since only a portion of the debt is paid off at a time, this allows people to consume more. The BoC says this means a greater focus needs to be put on the stock and flow of household debt. For those that missed that accounting class, stock is the amount of debt in dollar terms. Flows are the changes in levels, often expressed as a rate.
- Collateralized household debt. Yup, Canada’s addiction to using housing wealth as leverage is now a key factor in the economy. This segment will look at borrowers with two components:
- Residential mortgages. They plan on capturing it by taking housing investment, and multiplying it by the loan-to-value (LTV). This is problematic since bubbles exaggerate LTV ratios. But that’s another discussion for another day.
- The share of their current home equity. They’re hoping to capture the impact of home equity lines of credit (HELOC) here. It highlights how dependent people are on home equity in Canada. HELOCs are literally a major economic factor for consumption.
- Interest paid on debt. They plan on factoring in the interest paid on new loans, as well as the effective interest paid on debt.
The BoC Just Discovered Debt Can Influence Home Prices
Like Christopher Columbus discovering the Americas, the BoC has found debt contributes to home prices. A key improvement in the central bank’s new model is using more housing data to monitor the economy.
When discussing how the model keeps up with current trends, they cite innovation in housing. The BoC said, “… the main innovation is that borrowers now contribute to overall housing demand, allowing mortgage debt and HELOCs to influence prices.” Yup, they called it an innovation.
You know the stuff we write about here at Better Dwelling, but old-timey economists say it doesn’t matter? It turns out the bank’s models were wrong, and the dynamics of behavior do play a role in the value of asset prices. Who would have thought? I mean, other than our regular readers.
The changes may not seem like a big deal, but they can drastically alter the country’s monetary policy. Canada’s central bank focused largely on supply-side fixes. It never fully assessed the impact of demand, if at all. There was no consideration of how leverage impacts household wealth. No consideration of how the leverage on assets means greater wealth inequality. No focus on leverage can create demand, increasing the price of goods. In a country where most of a household’s wealth comes from debt-driven asset inflation. Wild.
Developing tools like this takes years, so parts of the model have been used to assess policy. However, it’s never played a primary role in forecasting and planning monetary policy. By including housing, the BoC will finally start to see what many Canadians face… instead of a technical document that in no way reflects their reality.
The biggest takeaway is the Canadian economy is so dependent on debt and housing, it got its own update. Not a small forecasting update either. This thing likely took a decade to develop, and is key to central bank plans. If it presents that much of an influence on the economy, measuring it properly will likely show more risk, real soon.
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Scare y to reflect on how the basic tool to asses the financial course of the nation is so dated to say the least. Or perhaps it was designed to give politicians & policy makers great leeway ?
Favourite line : You’re looking at two different economies, and their version only exists on paper.
One advantage of present model is that it allows Prime Ministers like Trudough to blissfully ignore reality .Although I do not think he needs help in that regard.
Very informative article ,I intend to re post if okay ?
I hope “re post” means you intend to share a link, and not a substantive portion of the article without paying them or a written waiver.
The latter is copyright infringement, and I hope they pursue monetary compensation. Would you let someone use your realtor license for a quick minute to process a transaction without compensation?
Wow, he asked permission. You can only expect that the answer from the author will have whatever qualifications the author wants. But I’m sure BD is considering your valuable advice.
What is it that you trade, Jim?
Insight
We have to realize the government uses policy to form the models, not the other way around. When you think of it this way, everything starts to make more sense.
TOTEM showing more risk and doing something about it are two different things.
You really don’t get how wacky the current state of re economy is until you understand how bad the existing tools they use are.
If their perspective is lowering interest rates allows people to increase consumption, how can they not understand it influences prices?
We saw that kind of thinking with the BoC when they blamed households for spending more on housing. They were apparently supposed to spend the exact same amount they usually do, with no variation on what they pay…
Did you not read the post ? I asked if it was okay ! I always include full link .In effect I am giving them a wider audience . I guess its easier to make sanctimonious pointless comments when you post anonymously ?
LOL is all I can say about the BOC modeling. They haven’t been following their own inflation data though, and keep making unqualified statements contrary to their models. Do we really expect them to actually change anything?
As some who was trained in a top university for modeling and economics and with long financial industry experience. I can tell you financial regulators have been getting update model output WITH real estate prices built in. What that means is the numbers most financial regulators see are the result of up to date modeling from most banks.
Now, with that being said. Modeling can only tell you so much. We just need to realize inflation is here as a result of money printing. Hence all assets that track inflation will go up. This creates a wealth gap. The only way I see for smart young people to overcome this is to buy real estate in second tier cities where the median household income is higher than Toronto. This will allow you a chance to build equity. Or you can buy stocks of future industries such as AI or electric vehicle or Asia Pacific oriented companies. This is not the time to sit on your money and hope prices will fall. It will not happen.
We heard it so many times in late 80s in Canada. In late 90s in Japan and mid 2000 in the US.
Bubble will burst.
Real Estates in Canada is going to collapse.
Buy all low and sell high. Real Estates or stocks. Be patient, and crash is going to come.
Be greedy when everyone is fearful.
Why are you trying to dispense financial advice? That’s not really why we are here.
Not to mention this is a community that includes other folks with rigorous post graduate technical training as well as extensive industry experience too.
Anytime someone needs to reference institutional brand to support a claim, it should speak volumes about their credibility.
The only thing to “realize” here is that when someone claims certainty about the future state of the world, they do not understand how complex dynamic systems work.
Putting that together, anyone who uses pedigree for influence and then makes a sweeping statement of certainty is contributing to the very systems that got us here in the first place.
Interesting fact, did you know folks mentally picture people with authoritative titles taller than others? That should give you some insights about what psychological tricks people try to play to prove a point. Be careful what you believe, but more importantly, why you believe it.
asking people to rush and buy even more assets (any kind it seems for you) is exactly what is making the bubble even bigger and dangerous…
It was ok time to buy real estates from 2018-2019 but not now.
The best time to buy stocks passed.
Unless govt./BoC can figure out how to improve foreign relations and bring business investment in, they will keep depending on housing to have GDP growth and improve employment.
When policy makers and monetary policy decision makers are blind to reality i.e. no problem with housing or debt, they’ll keep relying on fictitious plans as charted by political leaders to keep them in power.
If housing goes down, with itself it will take down a whole of people and retirement goals.
Can you believe any model used by any agency of the People’s Republic of Trudope?
What a complete and utter Joke.
Oh, they JUST realized that debt can contribute to higher home prices? Really? These are scholars getting paid how much to run the system? How quick would you be fired for being an incompetent ass at your job? 15 days? Not for these great honourable leaders of ours, they simply update the “model” every 15 years… ive been saying this for yearrrrs, even back when everyone was complaining and debating about “foreign buyers influencing the home prices”: interest rates and more money printing (devaluing your today dollars) forces people to make investments they otherwise wouldn’t, and therefore speculating and treating homes like investment tools. And what do we do? Turn around and blame the speculators the average everyday people in the middle class not necessarily trying to get RICH, but simply trying to protect their hard earned dollars from losing value due to money printing, due to “monetary policy”. And we blame them, not the people in charge who forgot to account for this in their model 15 years ago. Yes, Lowering interest rates to damn near ZERO might have an effect on people borrowing money to buy homes and outbid each other because a huge majority of people now have Access to MORE money to borrow against their own future, burdening themselves and others for longer and longer.
I know, lets bring in 35 or 40year mortgages next…
And maybe in another 15 years they will also update their model to account the increase in monetary supply (money) by 25% in one year. I can’t wait. We are so lucky to have such smart folks in charge. You and I are idiots compared to them, monetary policy is not something we would understand.
This is animal farm.
I’m not that conversant in economics. What I know is what I see. The home I grew up in Scarborough cost my parents $15,500. That home now costs around $1 million. All in 1 generation. The blind are leading the blind. This mess hurts the country on so many levels.
“Not that conversant in economics” exactly.
Not many people are. In fact the majority aren’t. Including myself.
But from what little i know, there is clearly a devaluation of currency. For a home to go from $15k to $1M. Dont be surprised to see it rise even more. Because the dollar you are holding today will be worth less in two to three years. All the amount of time you put in earning that dollar (after taxes of course) will buy you less and less things the longer you hold it.
People who have some money understand that holding their money in the bank to earn “savings” of less than 2% while inflation is going higher and higher than that number, does not incentivize a nation to become savers and not spenders. So people move their money (which will be less valuable in 2-5 years) into the thing that they believe will be more valuable in 2-5 years. Cant blame people for doing that simple thing, because its not fair to be effectively told the time you spent making your money will be worth less in 2-5 years. So more and more people buy assets the “protect” their hard earned money (which is really just a representation of their labour time), and of course the demand increases the price.
And we wonder why theres a wealth gap.