By Dr. Peter Andersen

Declining interest rates over the past four years have been a major contributor to the health of the housing industry. Housing starts in Canada have returned to levels that we never thought we would see again.
Starts rose above 200,000 in 2002 to 205,034 and went up again in 2004 to 218,426. This year looks even better - starts are running 10 per cent higher than last year, based on the first four months of the year. The primary driver behind this outstanding performance is not about to disappear this summer or fall, but it is expected to gradually lose its power looking further ahead into 2005 and 2006.
The next four years are likely to see a reversal of the interest rate trends that have been in place since 2000. The process has already begun. The North American bond market has seen interest rates rise by around 100 basis points since mid-March. Rates are still relatively low but the rate of increase is large, especially over such a short time period.
These increases are flowing into mortgages. The 5-year listed rate is now up to 6.70 per cent. This compares with a low of 5.70 per cent in March. This rebound can be expected to continue. Next year, under economic assumptions that are reasonable, the 5-year rate could be in the upper end of the 7.00 to 8.00 per cent range or even higher.

The inflation outlook
Future inflation trends will be a key determinant of how far interest rates will rise. The yield differential between conventional bonds and real return bonds, which protect investors from inflation, is one way to measure inflation expectations. This spread has now widened to 3.0 per cent, up from 2.2 per cent a year earlier, indicating a big shift in expected future inflation. Consensus forecasts, however, expect inflation to remain stable at around 2.0 per cent for the next two to three years.

Worries about consumer debt
Total outstanding consumer credit has increased by almost 20 per cent over the past two years and outstanding residential mortgage debt is up by about 17 per cent.
The combined total consumer debt now amounts to about $800 billion - an increase of $119 billion over the past 24 months. In comparison, personal disposable income is up by only $42 billion over this period and the ratio of debt to income has increased to 110 per cent from 99 per cent.
This has to be measured in a balance sheet approach, though. Asset valuations have also been increasing. Canadians have actually experienced an improvement in their financial position. Net worth has increased as a result of rising values for financial assets and real estate assets. In addition, Canadians have been able to replace high cost debt with low cost debt and achieve a big reduction in servicing costs.
Worries about a possible credit crunch brought on by rising interest rates and a housing bubble continue to appear in the media. Such a scenario is highly unlikely given the range of plausible economic forecasts. House price deflation would not seem possible, given a growing economy, declining unemployment, backlogs of demographic demand and acceptable housing affordability.

New house prices
The latest 12-month increase in the new housing price index of 5.6 per cent compares with a 2.5 per cent increase in the consumer price index. However, the CPI-adjusted real increase of 3.0 per cent is still relatively moderate.
Although builders are experiencing double-digit price increases for many building materials, big increases in land costs and shortages of skilled labour, higher costs are not being fully passed on to buyers.

Resale markets setting records
Unit sales in Canada's major markets set a new record last year, and this year they are are running 11.7 per cent higher than a year ago through the first five months.
They are above previous year-to-date levels in 22 out of 25 major markets. Halifax-Dartmouth, Saguenay-Lac Saint-Jean and Thunder Bay are the down markets. Durham Region (21.9 per cent) and Vancouver (21.1 per cent) show the largest increases. Unit sales are up by 15.5 per cent in Toronto, 9.9 per cent in Calgary and 14.0 per cent in Edmonton.

Renovation
Record setting years for Canada's resale housing market will support renovation spending for several years. The latest figures for residential renovation spending show a continued strong uptrend. In the first quarter of 2004, spending on major alterations and improvements was running 13.2 per cent higher than in the same quarter a year earlier. This was the fourth consecutive quarter of double-digit year-to-year growth in renovation spending. Most of the recent increases represent increased volumes of renovation activity rather than price increases. The inflation rate used by Statistics Canada in the latest quarterly renovation estimate is only 3.0 per cent.

Housing starts stay strong this year
The pick-up in housing starts activity this spring was so strong that we have again revised our starts forecast upward for 2004. At seasonally adjusted annual rates, starts averaged 240,200 units in April and May. We are now forecasting 223,000 starts in 2004, an increase of two per cent from last year. However, this could still prove to be too low.