#MacroMemo: August 21 - 25, 2017

Canadian housing update:

• Canadian home prices have risen rather astonishingly over the past decade, supported by low interest rates and ready credit.
• Various levels of government are now actively seeking to the slow the market.
• The latest changes focused on the Toronto area are having an effect:
• Home sales are now down by 39% YoY and the sales-to-new listings ratio has plummeted from an extreme seller’s market to a clear buyer’s market.
• Home prices are also lower, though one must first wade through the noise of dubious figures that fail to control for the type and quality of homes being sold. The proper measure of home prices admits that home prices are now falling – by nearly 5% in July after a slight June drop – but that the composite price is still a large 18% higher than a year ago.
• The Vancouver experience suggests that Toronto housing could continue to decline for several more months, but that a foreign buyer’s tax only dims a housing market for about half a year. A Toronto revival is thus conceivable by mid-autumn, presuming tightening central banks don’t get in the way too much.
• Toronto home prices are operating well beyond fair value – the cost of the average mortgage is around 40% higher than the historical norm versus income. While entirely conceivably, there is no guarantee nominal home prices will ever decline significantly given the alternate possibility that inflation and rising personal incomes eventually eat away at the affordability gap.
• Similarly, it is an open question the extent to which Toronto and Vancouver are becoming “international cities” where affordability is permanently offside and the majority will have to reset their expectations toward living in multi-unit dwellings.
• In contrast, Toronto construction activity is only running a little too high – perhaps around 20% above the historical norm. This brings conflicting implications. On the one hand, it argues that high home prices are a function of excessive (speculative) demand rather than inadequate housing supply. On the other hand, it suggests the pace of construction might have to slow at some point should demand retreat to levels consistent with household formation.
• Elsewhere in Canada, housing markets are strong. Vancouver home prices are reviving and now rising at 2% per month (a 25%+ per year clip). Victoria is up 18% YoY, though decelerating. Ottawa and Montreal – long laggards – are now managing their fastest home price gains in seven years and accelerating. Calgary home prices are finally rising again, though the level is still 4% below the peak of 2015.
• We have made a renewed effort to calculate the economic impact of Canada’s housing market, arriving at a figure in the range of 23% of GDP versus a historical norm of less than 20%. This estimate errs on the side of exaggerating the true size given the blurry interconnectedness of wealth effects and furniture & appliance purchases, but the biases should at least be reasonably steady over time. As such, we can indeed say that Canada’s housing market is generating several percentage points of artificial GDP that may eventually need to be given back.
• However, this aggregate quantification isn’t especially useful without estimating the responsiveness of various components to negative construction, resale and home price shocks. Some components of housing activity – such as paying rent – are fairly steady, and would not be overly affected by a sudden stop in housing. Others would come close to vanishing, such as the wealth effect.
• We estimate that a 25% drop in residential construction would subtract 1.5% from real GDP, a 25% drop in housing resales would subtract 0.4% and a 25% home price decline would subtract a whopping 4.0%. This clearly makes the point that home prices are the thing to watch, especially given that home prices are the most stretched to start with.
• We stick with a relatively middling scenario in which Canadian home prices stop rising at such a ferocious rate within the next few years, with the result that perhaps 1-2ppt of economic activity is lost over a multi-year period. But other scenarios are entirely conceivable, and can be roughly calculated with the elasticities above.

Canadian minimum wages:

• Canada is threatened by an adverse competitive wedge opening on several battlefields versus the U.S., including through trade barriers, labour laws, environmental laws, the regulatory environment and tax rates.
• Rising minimum wages represent among the more prominent labour market changes. These are occurring with particular punch in Ontario, Alberta and British Columbia, though admittedly matched in part by higher wages in certain U.S. jurisdictions.
• There are several debates concerning minimum wages. The most basic is between workers and employers, each of whom would like a larger slice of the revenue pie. Although businesses derive some indirect benefit in the form of additional demand when the minimum wage goes up (and perhaps also benefit from greater perceived social license), for the most part they understandably prefer low labour costs. On this front, higher minimum wages represent a slight negative for Canadian investors.
• A second debate revolves around whether low-income earners actually benefit from a higher minimum wage. The initial instinct is to say “obviously yes,” but theory and research suggest there is a trade-off. A higher minimum wage tends to result in less demand for low-wage workers. The question is whether the workers who manage to retain their jobs benefit enough from their higher income to more than offset those who lose their jobs or are given fewer working hours.
• For the most part, the minimum wage research of the past 25 years has found that rising minimum wages inflict surprisingly little damage to the hours worked of low income workers.
• It is not clear, however, that further minimum wage increases will permit the same happy outcome:
• It has long been thought that minimum wages can safely rise to around 40% of the median wage without doing any damage to low-income workers. However, the new $15 per hour proposals in various parts of Canada threaten to take Canada’s fraction from an already slightly heady 44% to something in excess of 50%.
• Research on Seattle’s recent experiment with a minimum wage rising steadily toward $15 (U.S.) also provides reason for pause. To be clear, there is research arguing both sides of the story, but the latest and seemingly best (though not yet exhaustive) working paper from the University of Washington argues that the costs have outweighed the benefits to low-income workers by roughly three to one. The average minimum-wage worker has suffered a 6.6% drop in their paycheques once reduced hours are factored into the mix.
• More research will be needed to provide the final word on Seattle, and by extension the jury is still out on whether Canada’s low income earners will truly benefit. One hopes that they will. Inequality is clearly a pressing concern that can be partially if imperfectly tackled via higher minimum wages. The imperfections in using this policy tool are that a non-trivial fraction of minimum wage earners come from wealthy families, the bulk of minimum wage earners are 24 years old or less, and minimum wage jobs tend to be a gateway toward higher earnings down the road more than they are a final destination.
• Using back-of-the-envelope calculations, we figure that the proposed minimum wage hikes will, over the next two years, raise the level of the country’s average wage by around 1.25%, increase consumer prices by about 0.5% and reduce corporate competitiveness by about 0.6%. The effect will of course vary enormously depending on the worker and company in question.

NAFTA negotiations update:

• An initial round of meetings among NAFTA signatories has concluded.
• It continues to seem to us that all parties are essentially talking past one another, with markedly different priorities and incompatible goals.
• The nature of negotiations is of course to arrive at a mutually agreeable solution with occasional sacrifices along the way, but given the gaping differences of opinion combined with the unrealistic aspiration of agreeing to a deal by the end of 2017 (recall that the TPP and CETA both took years to negotiate) one must acknowledge the significant risk that no deal is struck.
• Whether the original NAFTA ultimately remains, a trivially adjusted one takes its place or NAFTA is unilaterally cancelled by President Trump is at present uncertain. But the prospect of large changes is arguably declining.

Central banks:

• The U.S. Fed Minutes suggested a bit less confidence in the need for monetary tightening given low inflation, but still left a reasonable expectation of a rate hike later this year and the start of balance sheet reduction in the fall.
• The famous and occasionally highly influential Jackson Hole conference begins on Thursday. The selected topic is “fostering a dynamic global economy.” There will be many interesting academic papers released on the subject, but the real fireworks tend to be when central bank leaders speak. Fed Chair Yellen and ECB head Draghi will both opine on Friday. Given weakness in the U.S. dollar and inflation since prior utterances, there is a glimmer of hope that something new will be said, with a risk that it is on the dovish side.

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Published August 21, 2017