Slowdown in Canada’s Housing Sector Shows Risk of Higher Rates

In Canada, the impact on housing carries extra weight, given the outsize role the sector has played in fueling the country’s recovery from Covid-19 pandemic lockdowns and restrictions. Housing accounted for about 20% of Canada’s economic growth last year, and investment in Canadian residential real estate overtook spending by businesses on structures, machinery and equipment starting in mid-2020.

Prices in Canada’s housing market have accelerated at a faster pace relative to most developed-world peers for more than a decade, according to data from the Federal Reserve Bank of Dallas. The country’s housing market recorded further growth during the public health crisis, fueled by demand for bigger homes and rock-bottom borrowing rates.

As of March, residential home prices in Canada had surged 53% from February 2020, according to the Canadian Real Estate Association’s main house-price index.

Even the U.S. didn’t see such a run-up during the pandemic. The S&P CoreLogic Case-Shiller National Home Price Index, which measures average home prices in major metropolitan areas across the U.S., rose about 35% in the same period.

The Bank of Canada, like the Federal Reserve and other central banks, is moving quickly to tighten monetary policy in the face of the highest inflation since the early 1990s. Canadian central bank officials acknowledge that annual inflation, as of April nearing 7%, accelerated faster than forecast. This prompted them to lift the benchmark rate in March by a quarter point to 0.50%, followed by a half-percentage point increase in April to 1.0%.

Bank of Canada Gov.

Tiff Macklem

told lawmakers in April that officials had been caught off guard by the persistence and pervasiveness of supply-chain constraints and their effects on inflation. The war in Ukraine has led to higher prices for fuel, food and other commodities. “We did get some things wrong,” he said.

Yet Bank of Canada officials say they are confident they can raise rates and bring inflation down to its 2% target while maintaining solid growth of 4.2% this year and then slowing to 3.2% in 2023. Mr. Macklem has said that officials could lift rates by another half-point in June.

The goal is to raise the benchmark rate until it reaches neutral, or the level at which monetary policy neither stimulates nor shrinks economic activity, central bank officials said. The bank estimates neutral to be between 2% and 3%. Once at that point, officials would reassess how the economy is responding before deciding next steps, Mr. Macklem said.

Economists and real-estate agents say early housing data suggest the central bank is underestimating the fallout from higher rates on economic activity. Data for Canadian existing-home sales in April are set for release on Monday, but early figures from local real-estate boards in Toronto and Vancouver, British Columbia, point to a marked slowdown nationwide.

Sales in Toronto, Canada’s largest urban area, fell 27% in April from the prior month, and 41.2% from the same period a year ago. Over the past 10 years, home sales across the Toronto area have increased by an average of 8% between March and April, which marks the start of the busy spring house-hunting season, according to data compiled by Realosophy, a Toronto real-estate brokerage.

The average price for a residence in Toronto declined 3.5% in April from March to 1.25 million Canadian dollars, or the equivalent of $961,000. That remains 15% higher than a year ago, although the annual gain for April marks a slowdown from March’s 18.5% advance and February’s 27% jump. The share of Toronto-area homes that sold above the original asking price fell in April to 69%, down from a peak of over 80% as of February.

A similar picture has emerged in Vancouver. Home sales in April fell about 25% from the previous month, and 34% from the same year-ago month. Steve Saretsky, a Vancouver real-estate agent, told clients in a monthly note that house prices, mostly in suburbs, are beginning to slide, and he expects declines to become more pronounced later this year.

“There should be no surprise that sales activity has fallen precipitously. Prices need to adjust for the higher cost of borrowing,” he said.

Mortgage rates, which lenders set based on long-term bond yields, have surged from roughly 1.5% in the fall to over 4% this month, or a 12-year high.

“I haven’t seen a thrust in fixed rates like this, even during the credit crisis” of 2008 and 2009, said

Robert McLister,

founder of MortgageLogic.News. “This was a shock in the system.”

Prolonged weakness in housing could quickly spill over to other parts of the economy, such as consumer spending and construction, economists say.

Stephen Brown,

economist at forecasting company Capital Economics, said that he believes the Bank of Canada won’t lift rates as aggressively as expected because of the potentially wide impact. Traders in the overnight-index swap market predict the central bank’s policy rate will rise to 3.25% in 2023.

“The worrying thing is this is only really the first month of weakness in housing,” said Mr. Brown, who is forecasting a 10% drop in housing prices over the next 12 months. “If house prices fell by much more than we expect, which clearly should not be ruled out given their elevated level, a recession would be almost inevitable.”

Bank of Canada’s second-highest ranking official,

Carolyn Rogers,

told a Toronto audience in early May that higher interest rates are necessary to cool demand in an overheating economy, including the housing market.

“Housing price growth is unsustainably strong in Canada, and it would not be a bad thing for the growth in housing prices to moderate a bit,” she said.

Write to Paul Vieira at paul.vieira@wsj.com

In Canada, the impact on housing carries extra weight, given the outsize role the sector has played in fueling the country’s recovery from Covid-19 pandemic lockdowns and restrictions. Housing accounted for about 20% of Canada’s economic growth last year, and investment in Canadian residential real estate overtook spending by businesses on structures, machinery and equipment starting in mid-2020.

Prices in Canada’s housing market have accelerated at a faster pace relative to most developed-world peers for more than a decade, according to data from the Federal Reserve Bank of Dallas. The country’s housing market recorded further growth during the public health crisis, fueled by demand for bigger homes and rock-bottom borrowing rates.

As of March, residential home prices in Canada had surged 53% from February 2020, according to the Canadian Real Estate Association’s main house-price index.

Even the U.S. didn’t see such a run-up during the pandemic. The S&P CoreLogic Case-Shiller National Home Price Index, which measures average home prices in major metropolitan areas across the U.S., rose about 35% in the same period.

The Bank of Canada, like the Federal Reserve and other central banks, is moving quickly to tighten monetary policy in the face of the highest inflation since the early 1990s. Canadian central bank officials acknowledge that annual inflation, as of April nearing 7%, accelerated faster than forecast. This prompted them to lift the benchmark rate in March by a quarter point to 0.50%, followed by a half-percentage point increase in April to 1.0%.

Bank of Canada Gov.

Tiff Macklem

told lawmakers in April that officials had been caught off guard by the persistence and pervasiveness of supply-chain constraints and their effects on inflation. The war in Ukraine has led to higher prices for fuel, food and other commodities. “We did get some things wrong,” he said.

Yet Bank of Canada officials say they are confident they can raise rates and bring inflation down to its 2% target while maintaining solid growth of 4.2% this year and then slowing to 3.2% in 2023. Mr. Macklem has said that officials could lift rates by another half-point in June.

The goal is to raise the benchmark rate until it reaches neutral, or the level at which monetary policy neither stimulates nor shrinks economic activity, central bank officials said. The bank estimates neutral to be between 2% and 3%. Once at that point, officials would reassess how the economy is responding before deciding next steps, Mr. Macklem said.

Economists and real-estate agents say early housing data suggest the central bank is underestimating the fallout from higher rates on economic activity. Data for Canadian existing-home sales in April are set for release on Monday, but early figures from local real-estate boards in Toronto and Vancouver, British Columbia, point to a marked slowdown nationwide.

Sales in Toronto, Canada’s largest urban area, fell 27% in April from the prior month, and 41.2% from the same period a year ago. Over the past 10 years, home sales across the Toronto area have increased by an average of 8% between March and April, which marks the start of the busy spring house-hunting season, according to data compiled by Realosophy, a Toronto real-estate brokerage.

The average price for a residence in Toronto declined 3.5% in April from March to 1.25 million Canadian dollars, or the equivalent of $961,000. That remains 15% higher than a year ago, although the annual gain for April marks a slowdown from March’s 18.5% advance and February’s 27% jump. The share of Toronto-area homes that sold above the original asking price fell in April to 69%, down from a peak of over 80% as of February.

A similar picture has emerged in Vancouver. Home sales in April fell about 25% from the previous month, and 34% from the same year-ago month. Steve Saretsky, a Vancouver real-estate agent, told clients in a monthly note that house prices, mostly in suburbs, are beginning to slide, and he expects declines to become more pronounced later this year.

“There should be no surprise that sales activity has fallen precipitously. Prices need to adjust for the higher cost of borrowing,” he said.

Mortgage rates, which lenders set based on long-term bond yields, have surged from roughly 1.5% in the fall to over 4% this month, or a 12-year high.

“I haven’t seen a thrust in fixed rates like this, even during the credit crisis” of 2008 and 2009, said

Robert McLister,

founder of MortgageLogic.News. “This was a shock in the system.”

Prolonged weakness in housing could quickly spill over to other parts of the economy, such as consumer spending and construction, economists say.

Stephen Brown,

economist at forecasting company Capital Economics, said that he believes the Bank of Canada won’t lift rates as aggressively as expected because of the potentially wide impact. Traders in the overnight-index swap market predict the central bank’s policy rate will rise to 3.25% in 2023.

“The worrying thing is this is only really the first month of weakness in housing,” said Mr. Brown, who is forecasting a 10% drop in housing prices over the next 12 months. “If house prices fell by much more than we expect, which clearly should not be ruled out given their elevated level, a recession would be almost inevitable.”

Bank of Canada’s second-highest ranking official,

Carolyn Rogers,

told a Toronto audience in early May that higher interest rates are necessary to cool demand in an overheating economy, including the housing market.

“Housing price growth is unsustainably strong in Canada, and it would not be a bad thing for the growth in housing prices to moderate a bit,” she said.

Write to Paul Vieira at paul.vieira@wsj.com