Canada’s central bank is “chasing its tail,” warns a new Bank of Canada (BoC) staff paper. The researchers studied the impact of including mortgage interest in the Consumer Price Index (CPI), discovering the circular logic. The BoC sets interest rates based on CPI, but CPI includes mortgage interest costs driven by those very rates. As a result, slashing rates to stimulate inflation lowers CPI readings, while rate hikes drive CPI higher—the exact opposite signal it’s supposed to provide. They find that excluding mortgage interest costs can lead to less volatile cycles and minimize the drag on economic output in a downturn.
Monetary Policy 101: How Central Banks Should Work
Not everyone is fluent in bankster, so let’s do a quick Monetary Policy 101. The BoC’s primary mandate is inflation control, keeping CPI near its 2% annual target. Its main tool is the overnight rate, influencing short-term borrowing costs. When inflation is low, the BoC cuts rates to incentivize borrowing, boost demand, and raise prices. When inflation is high, it hikes rates to make credit more expensive, choking demand and cooling price growth.
Mortgage rates are driven by inflation. Investors try to avoid real losses by factoring inflation into mortgage rates. Variable-rate mortgages track the overnight rate, which responds to current CPI readings. Fixed-rate mortgages track government bond yields, which reflect inflation expectations over the term. For example, 5-year fixed-rate pricing follows 5-year Government of Canada bond yields, which track inflation expectations over 5 years.
Bank of Canada Is “Chasing Its Own Tail”
Inflation seems important, eh? It is, and we’ve been pointing out this issue for years: Canadian CPI includes mortgage interest rates, creating the inflation equivalent of a human centipede. Rate hikes to slow inflation create higher CPI readings, and rate cuts to raise inflation produce lower CPI readings. The issue is amplified in periods where the BoC makes abrupt and sharp decisions, like during the recent cycle.
Most countries do not include interest costs to avoid this loop, making Canada an outlier. This is part of the reason the BoC has a sterling reputation among central banks when it comes to performance. Central bank decisions take 18 to 24 months to fully influence CPI, but the BoC gets it done within weeks. That’s because CPI in Canada measures what the BoC just did, not how it trickles through prices in the economy.
BoC researchers are now acknowledging this problem. “Responding to large fluctuations in mortgage interest cost (MIC) inflation can create unnecessary oscillations in economic activity because monetary policy ‘chases its own tail’ in the sense that it tries to stabilize shelter costs induced by past monetary policy decisions,” explain BoC staff researchers Michael Irwin and Matias Vieyra.
Yes, BoC staff just said the central bank is effectively acting like a naive puppy. The volatile and extreme central bank cycle we just saw wasn’t addressing inflation, but the central bank was trying to eliminate the extreme moves it was making. Seriously.
The Impact of Excluding Mortgage Interest from CPI
To determine the impact of tail chasing, the BoC researchers modelled the economy twice: once with the current rules, and once where the central bank pretends shelter inflation doesn’t exist, called “looking through.”
Under the model we’re living in, when home prices surge and drive overall inflation higher, the BoC is forced to raise rates. This acts as a brake for the broader economy, shrinking output and cutting into everyday consumer spending. Under the alternative where mortgage interest costs are ignored, the drop in output is virtually erased, and the drop in consumer spending is cut in half.
“Even in instances where the aggregate effects of responding to shelter inflation are small, there are large and contrasting welfare effects at the individual level,” the BoC researchers explain.
At the macro level, both scenarios work out to less than the typical margin of error. However, the researchers stress compositional changes are more dramatic. The gains of one group cancel out another, suggesting the outcome is zero-sum.
Bank of Canada’s Inflation Targeting Is A Wealth Redistribution Scheme, But Not The Way Most Assume
The overall economic impact of tweaking the inflation target looks like a rounding error on paper, but it masks a massive redistribution of wealth. The researchers present renters and highly leveraged homeowners as having opposite interests. While the average household sees a negligible impact of up to 0.1% of income, the impact is amplified for renters and highly leveraged homeowners.
In a housing boom, the researchers suggest renters have a preference for the existing system, targeting shelter. While negligible for the average household, it has an extreme impact on highly indebted households, hitting them 6x harder during a housing boom, and over 20x harder during a downturn. On the flip side, they see the alternative scenario without consideration of mortgage costs as hitting renters more. Or bluntly put, we’re damned if you do, damned if you don’t.
The BoC researchers come to the natural conclusion that renters prefer the existing system of targeting shelter [record scratch]… wait, what? The research is great, but that final note doesn’t quite agree with the reality we currently live in, right? I might be in a bubble (not just because I live in Toronto), but I haven’t heard a single renter tell me they’re thriving in this model.
Here’s where the disconnect occurs:
- The current approach guarantees boom-bust cycles. Part of the reason the BoC took so long to hike is the direct impact of hikes on CPI. Ultimately, this resulted in much higher inflation readings than needed, and sharp cuts—maximizing pain to both homeowners and renters. (We covered the other reason in detail here).
- Low rates benefited a small share of homeowners. A study from the Dutch central bank shows low rate shocks transfer up to 6% of the economy to the top 1%. Most people fail to realize that the frenzy in Canada was primarily real estate investors, who priced out end users. Heck, investors scooped up to 80% of pre-construction in markets like Toronto.
- Highly indebted households are assumed to be living hand-to-mouth, meaning they lack savings. This may suggest modest incomes, but those without deep pockets have a mortgage cap of 4.5x income—smaller in reality, as leverage calculations include taxes, heating, and maintenance. Banks make exceptions to strict debt ratios for those who demonstrate low risk (a.k.a. high-income earners with heavy assets). The vulnerability isn’t that they’re poor; it’s that our system encourages nearly “risk-free” housing leverage.
- Low rates stimulate investment, not just housing. Incentives such as the BoC’s quantitative easing, combined with policymakers’ stimulus, distorted where those investments flowed. This redirects cheap credit away from productive investments that build real wealth, funnelling it instead toward risk-free housing wealth.
CPI is meant to measure the cost of consumption, and credit isn’t consumption by definition. Financing influences consumption, but it doesn’t directly impact it. Let’s say policymakers launch a Crown corp called Canada Bread & Loan (CBAL). They provide loans at 6% compounded semi-annually over a 25-year term, allowing you to turn an $8 loaf of bread into 25 payments of just $0.63 per year. Sweet!
Oh no, the cost of bread climbed to $12, but interest rates fell to 2% per year. You and I would say the cost of bread climbed 50%, but policymakers would say: “Stop measuring bread, measure the payments, which fell over 1%! Time for emergency rate cuts to save the economy!”
Would you consider us in a deflationary spiral? Of course not, but that’s how Canada measures housing.
Ultimately, the real issue is central bank scope creep. Its primary mandate is inflation control, ensuring purchasing power doesn’t erode too fast. Instead, the BoC is focused on its influence beyond its mandate, capturing tools to undermine policies with zero accountability.
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