The housing market stands at a perplexing crossroads. While central banks maintain elevated interest rates to combat inflation, they inadvertently suppress the very solution that could address one of inflation’s largest drivers—housing costs. The paradox is stark: higher interest rates, aimed at cooling inflation, are throttling the supply of new housing, keeping shelter costs elevated and inflation stubbornly persistent.
The Triple Threat to Housing Supply
Higher interest rates stifle new housing supply through three interrelated mechanisms. Each reflects how elevated borrowing costs ripple through the housing market, discouraging new construction and perpetuating affordability challenges.
1. Risk Aversion from Developers Due to Lower Buyer Demand
Higher interest rates reduce prospective buyers’ purchasing power. Mortgage affordability declines as monthly payments rise, sidelining many would-be homeowners. This suppressed demand creates uncertainty for developers. Why break ground on a new project if the pool of eligible buyers has shrunk? Developers, naturally risk-averse, hesitate to invest in projects that may struggle to find buyers upon completion. This self-reinforcing cycle keeps new housing starts below what the market needs.
2. Increased Financing Costs and Project Risk
The cost of financing construction and land acquisition climbs in tandem with interest rates. Developers must secure loans for land, materials, and labor—all at elevated borrowing costs. Moreover, higher rates heighten the financial risk of project delays. A construction timeline that stretches an extra six months could significantly increase interest payments, further eroding project viability. This financial strain discourages developers from pursuing new projects, exacerbating the supply shortage.
3. CAP Rate Misalignment for Rental Housing
New rental housing faces an additional hurdle: the capitalization (CAP) rate. This metric, representing the return on investment for rental properties, must exceed financing and construction costs to justify development. With current interest rates, the CAP rates required to make rental projects viable simply don’t pencil out. Developers, faced with the choice between building at a loss or waiting for more favorable conditions, overwhelmingly choose the latter.
The Inflation Paradox: Interest Rates Feeding Housing Inflation
Central banks, including the Federal Reserve and the Bank of Canada, justify higher interest rates as a tool to curb inflation. Yet, the largest single component of inflation measurements—housing costs—remains elevated precisely because of those same interest rates. It’s a self-defeating cycle: higher rates suppress supply, supply shortages drive up prices, and elevated prices keep inflation high, justifying continued rate hikes.
Why Construction Costs Remain Stubbornly High
Despite higher interest rates, construction costs have not meaningfully declined. This resilience ties to a deeper economic reality—the fear of deflation. As Ben Bernanke explains in his Essays on the Great Depression, deflation poses greater systemic risks than inflation due to “wage stickiness.” If household incomes fall while fixed debt obligations remain, consumer confidence collapses, and banking systems face existential threats.
Since labour constitutes a significant portion of construction costs, wage stickiness explains why those costs remain elevated. Policymakers, understandably wary of wage deflation, prioritize economic stability over marginal cost reductions. Furthermore, regulatory improvements—such as enhanced seismic standards, accessibility mandates, weatherproofing, and energy efficiency—have increased construction quality, further entrenching higher costs. Add to this the scarcity of developable land, constrained by green space protections, and the foundation for persistently high housing prices becomes clear.
The Path Forward: Longer Amortizations and Rate Adjustments
Stephen Poloz, former Governor of the Bank of Canada, suggests a potential path forward: longer mortgage amortization periods. As he argues, taking out a 50-year mortgage for a higher-priced urban home makes as much sense as a 25-year mortgage for a rural property. This approach could bridge the gap between current housing costs and affordability, enabling more households to access homeownership without triggering deflationary pressures. With life expectancy projected to increase in the future, a 50-year amortization could very well represent the same portion of an adult’s working tenure as a 25-year amortization did in the 1960s.
However, unlocking significant new housing supply ultimately hinges on interest rate adjustments. Without lower borrowing costs, developers will remain sidelined, rental housing will remain economically unfeasible, and affordability will remain out of reach for many.
Conclusion: Breaking the Cage
The current interest rate environment, designed to combat inflation, paradoxically perpetuates it by constraining new housing supply. Until policymakers reconcile the need for price stability with the realities of housing production, the market will remain in stasis—hostage to the very interest rates intended to restore balance. Unlocking new housing requires not just vigilance against inflation but also an understanding that new housing supply is a critical lever in restoring economic balance. Only by addressing both sides of the equation can we hope to break the interest rate cage and build the homes communities desperately need.