Inflation not good news for builders
By Dr. Peter Andersen

The inflation risk is higher now in the wake of the hurricanes. This is not good news for Canada's new home builders and renovators as it could mean more aggressive interest rate increases by the Fed and the Bank of Canada.
The hurricane shock has dislodged inflationary expectations. A survey by the U.S. Conference Board shows a big jump in expected inflation. The energy infrastructure in the Gulf Region survived the storms but will not be restored to full operating capacity until sometime next year. This means sustained high prices for crude oil, gasoline, natural gas and electricity. Home heating costs will be up sharply this winter. Some estimates are as high as 50 per cent. This will fuel the increasing uncertainty on where inflation is headed.
The underlying strength of the U.S. and Canadian economies is adding to inflation risk. The U.S. economy is showing greater resilience than expected. Reconstruction and federal aid will provide a strong fiscal push in 2006. With the U.S. economy operating close to full capacity, such stimulus is coming at the wrong time. It could encourage the pass-through of high energy costs into general inflation. A number of companies have recently announced that they intend to adjust their pricing upward.

Damage to the energy infrastructure
The effect of Katrina and Rita on oil and natural gas production in the Gulf of Mexico is still uncertain. In early October, 90 per cent of Gulf oil production and 72 per cent of natural gas production remained shut down.
The potential for a prolonged loss of natural gas output is particularly troublesome. Unlike crude oil, there is no emergency stockpile of natural gas. In addition, there is no natural gas import safety valve to ease the shortage. The near-month price of natural gas has soared to $13.10 per thousand cubic feet. The price has more than doubled in the past year.
Households will not feel the full impact because many utilities signed long-term contracts that locked-in lower prices. Nonetheless, homeowners that use gas will see a large increase in heating costs this winter. In addition, electricity prices might increase by a comparable amount.
Given the likelihood that we are facing a prolonged period of high energy prices, conservation will increasingly become a high priority. This means strong energy retrofit demand as consumers respond to high energy costs.

Housing Starts Have Peaked
It is becoming increasingly evident that Canada's housing cycle has peaked. Single-detached housing starts have been trending steadily downward since last fall. Single-detached starts are down by 10 per cent in urban areas on a YTD basis through the first nine months of 2005. Total housing starts show only a five per cent comparable decline as a temporary surge in high-rise multiple unit activity has provided some offset. Also, Alberta's oil boom has masked the declines being experienced in starts in other parts of Canada.

House prices
A good argument against the possibility of a housing bubble in Canada is the fact that new house prices show only modest rates of increase. The latest figures show that the 12-month increase has been slowing down, with the average new house price in August up by only 4.6 per cent from August of 2004, despite cost pressure from building materials and energy. In mid-2004, the inflation rate for new house prices hit a cyclical peak of 6.2 per cent.
Price increases for resale homes are running at a much higher rate than for new housing. The national average resale price is up by 11.9 per cent year-over-year in August.

Strong existing home sales
Canada's existing housing market has been much stronger than expected. After consecutive record sales years in 2003 and 2004, sales had been expected to moderate in 2005. Strong sales this summer though point to another new all-time high for transactions in 2005. Resale activity in August was substantially greater than the previous monthly sales record, set in June 2005.
This is good news for Canada's new home builders and renovators. An upbeat resale market sets a positive tone for the new housing market and also provides liquidity. It helps empty-nesters sell their large family homes and move into new and more appropriate accommodation. Renovators will continue to have a backlog of work, provided that the economy and interest rates remain relatively stable, as people renovate when they move.

Mortgage rates are moving up
Mortgage rates have begun what will probably be an extended period of rate increases. However, they will be increasing from low levels and should not move into the danger zone for housing until later in 2007 or 2008. An abrupt change in the immediate inflation environment in North America is not anticipated but central banks have the responsibility of looking ahead to future developments. The Fed and the Bank of Canada can be expected to react in a proactive manner if energy inflation begins to be passed through into expectations and general pricing decisions.

Our housing start forecast
Given our expectation of a gradual increase in mortgage rates from low levels, housing demand is expected to ease back, rather than to decline sharply. We do not see a boom or bust scenario in Canada. Housing starts are expected to steadily decline through the rest of the decade but in 2006 and 2007 they are expected to stay at levels that would have been viewed very favourably in the 1990s. The 10-year average from 1990 to 1999 was 148,600 units.

Lumber Prices
After a post-Katrina buying panic, lumber prices have settled back again, with the benchmark price down to around US$320 per thousand board feet. Rebuilding in the Gulf region is expected to occur slowly and be spread out over several years. Nonetheless, the average lumber price next year is likely to be substantially higher than the current price and perhaps even higher than the estimated average of US$360 in 2005. There has been major damage to commercial timberland in the southern United States. In addition, U.S. housing starts are expected to remain relatively high in 2006, in excess of 1.9 million units.