Apartment building

To appropriately calibrate monetary policy, the Bank of Canada should exclude the biggest source of inflation — housing costs — from its deliberations, TD Bank economists suggest.

The bank’s analysts argue in a report that shelter costs, which currently account for about half of inflation, represent the biggest obstacle to the Bank of Canada reaching its inflation target and subsequently easing monetary policy.

“Mortgage interest costs are rising at the fastest pace ever, while rents have soared alongside low vacancies,” the report said. “The outsized impact of shelter costs is keeping measures of underlying inflation higher in Canada than in other major economies.”

The report also argues the central bank has limited ability to curb housing costs in the short term. After running various scenarios, it concludes that shelter inflation will average close to 6% over 2024 regardless of how quickly the Bank of Canada cuts rates.

At that level, other inflation sources would need to be close to zero for the headline inflation reading to drop to the central bank’s 2% target, the report noted, and “that is highly unlikely outside of a significant recession.”

As a result, the Bank of Canada’s existing inflation metrics are becoming increasingly ineffective at accurately reflecting the state of the economy.

“[A] good measure of inflation is one that moves with the economy and doesn’t have a single sector skewing the index,” the report said. Yet the central bank’s current measures “have become less connected with the economic cycle due to the influence of structural factors related to housing.”

The report argues the Bank of Canada must be able to set aside inflated shelter costs in setting monetary policy — implying that it must be able to withstand higher headline inflation while easing interest rates.

“[T]he longer the Bank of Canada continues to look at inflation through its current lens, the longer Canadians will have to bear the weight of a heavily restrictive policy rate,” the TD report said.