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Simply, this means that the Bank expects to raise interest rates sooner than other central banks, most particularly, the Fed and the ECB. The government also continues to lament the high level of household debt relative to income, claiming it is now above the level posted in the U.S. at the peak of the housing bubble. (I dispute this. According to our calculations, comparing apples-to-apples data, the Canadian ratio is well below the U.S. peak, although it is a bit above today’s much-reduced U.S. debt ratio.)

It is true, however, that household debt in Canada is near a record high relative to income. This is the direct reflection of record-low interest rates. To date, debt-servicing costs are well within historical norms; but, clearly, should interest rates rise significantly, households that borrowed with little or no money down could find themselves considerably overextended. The Bank of Canada estimates that a renormalization of interest rates (requiring a 3¼ percentage point rise in overnight rates) would increase that proportion of households from about 7% currently to roughly 10%. As a result of these concerns, the government has tightened insured mortgage credit conditions, reducing maximum amortization from 40-years (in 2006) to 25-years and increasing the minimum downpayment from zero to 5 %. Judging from housing data in August and September, the latest wave of tightening has had a meaningful impact in slowing home sales, especially in Vancouver and Toronto, but elsewhere as well.

House prices for the country as a whole are off their earlier highs, notably in British Columbia, and further softening is likely in the next year. We should be careful what we wish for. No one wants a meltdown in the housing market, but the constant drumroll of household debt reduction can have unintended consequences. If sufficient numbers of households expect a decline in prices, the prophecy can be self-fulfilling. Many are remaining on the sidelines with the thought that housing can only get cheaper. To be sure, unlike the U.S., there is no pent-up demand for housing or for housing construction. Indeed, residential construction activity is likely to contract in the current quarter and through much of next year. This is a hugely important sector of the economy, having meaningful spinoff effects on employment, consumption and corporate profitability.

Our economy has already been dampened by inventory depletion, a deteriorating net export position and a large current account deficit. Auto sales have likely peaked and fiscal drag continues, albeit at a slower pace than earlier this cycle. One ray of strength is commercial real estate development and investment in machinery and equipment, although that will be weakened if the Bank of Canada tightens prematurely. Bottom Line: The Canadian economy might not be as close to full-employment as we think. With an overvalued currency, tightened credit conditions and the prospect of higher interest rates, the economy could be vulnerable to a further slowdown from the under-2% pace recorded so far this year. Emerging economy demand for commodities might also weaken further as growth prospects in China,

India and Brazil have dimmed and Europe is still mired in austerity-induced recession and debt overload. The Canadian stock market has meaningfully underperformed bourses in much of the rest of the world, which might be foreshadowing these risks of weaker-than-expected activity.