As the global battle to tame inflation enters its next phase, Canada’s housing market offers a glimpse of what could play out for many other developed nations: a game of chicken between central bankers and consumers.

It started when the Bank of Canada paused its campaign of interest-rate hikes earlier this year, dutifully warning they could go higher still and would at least stay elevated for some time. But no one seemed to believe it. House hunters promptly swarmed back into the market.

Ashley Cortiula was one of them. After the Bank of Canada’s eight successive rate hikes, she figured cuts must be next, whatever the central bank said. So in May, when she bought her townhouse in Hamilton, a city an hour south of Toronto, Cortiula chose a variable-rate mortgage, which moves in step with the central bank’s benchmark, instead of a fixed-rate loan. “I think everyone had the same thought, that they were at the peak because they were so high, and they could only go down from there,” she says of interest rates. “How much higher can they go?”

Even the financial market pros expected the same: At the time, trading in interest-rate swaps put the odds of the Bank of Canada cutting rates by the end of the year at around 100 per cent, according to Bloomberg calculations. But in June, after the broader economy rebounded along with home prices, the central bank ended up raising rates again to slow down everything. It followed up that hike with another one this month, singling out the housing market as a source of persistent inflation.

Cortiula says she left room in her monthly budget just in case rates rose, so she isn’t worried. And she still believes it probably won’t be long before the Bank of Canada’s benchmark goes the other way, and she’ll end up saving money in the end. “I still have hope that it might come down in the fall,” she says of the central bank’s benchmark rate. “I just think you can never go wrong with real estate.”

This sentiment sums up the quandary facing policymakers around the world. Although Canada may be an extreme case–its housing boom lasted longer and left its consumers more heavily indebted than most–it’s not the only developed country that experienced a sustained period of interest rates grinding steadily lower and home prices doing the opposite.

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Even though rates have shot up more recently, higher borrowing costs still don’t feel normal, and many people are sceptical that they can keep going up. So people keep buying homes, which can put upward pressure on the overall inflation rate.

House prices in the US, Australia, New Zealand and Sweden have staged their own rebounds in recent months as well, as speculation builds that interest rates may be nearing their peak in those countries, too.

That pressure is forcing central bankers to grapple with questions of psychology, as they try to figure out how to get people to recognise that high interest rates can last and real estate prices can fall.

“They can try to jack up interest rates to make buying a house more painful,” says Michael Seiler, an economist who’s studied how psychology affects real estate markets at William & Mary’s Raymond A Mason School of Business in Williamsburg, Virginia.

But raising rates further to curb house price inflation could also provoke a recession that’s much worse, he says: “You’re going to have to experience some pain. It’s which do you want, a punch in the arm or a punch in the leg?”

Although housing markets play into each country’s inflation calculations differently–in Canada the prices of newly built homes and rental rates are more important than resale values–a price surge will usually put upward pressure on the official metric, which is why central bankers pay attention.

The housing market is also an indicator, and driver, of activity in the broader economy and is generally one of the parts most susceptible to interest-rate changes given how mortgage rates dictate what buyers can afford.

So if the housing market booms after interest rates have gone up, it’s a sign that rates may not be high enough now, and they certainly won’t be, as that activity starts seeping into the rest of the economy. This is why, when it got back to hiking in June, the Bank of Canada cited housing market strength as one reason for maintaining the pressure.

Before the decline in home values last year, Canada experienced the longest sustained real estate boom in the world. There were price dips in that period, but they were brief, and overall prices rose a world-beating 553 per cent in the 25 years ending in March 2022, when last year’s slide began. That boom left a lot of homeowners with substantial equity they can use to buy bigger properties or help their own children acquire properties with gifted down payments or loans today, regardless of where interest rates are.

“Most adults have experienced more of a bull market than a bear market,” says Adil Dinani, a real estate broker in Vancouver. “The appetite for real estate ownership across Canada is very, very strong. And it’s rooted in the notion that real estate is the best investment asset class.”

One theory for Canadian real estate’s long bull run is that falling interest rates, which made the cost of borrowing cheaper, allowed people to afford more expensive homes. To the extent that this theory is true, the Bank of Canada rate hikes should limit price increases.

The same can be said of places such as the US, the UK and various European countries, where interest rates have also been more or less falling since the 2008 financial crisis.

But another theory is that there simply aren’t enough homes. Although Canada’s world-leading, immigration-driven population growth makes the demand side of this equation unusually acute there, the factors restricting supply in Canada–zoning rules, a lack of skilled labour for construction, high materials costs–are the same in other developed nations experiencing housing shortages.

Addressing those problems is outside the scope of the Bank of Canada, or any other central bank, whose only tool is interest rates.

“It’s going to take a massive shift to change people’s mindsets,” says Robert Marsiglio, a real estate agent in the Toronto area, of the psychology he’s seeing in the market there. “They hear ‘pause,’ and they figure, ‘OK, pause is followed by cuts. Let’s get into this thing before prices go ballistic again.’”

With Canada as a cautionary tale, and with the hope of keeping consumers from falling back into this mentality, Federal Reserve Chair Jerome Powell all but promised more rate hikes even as he initiated his own pause last month, and the Bank of England shocked markets by doubling the pace of its own hikes.

So far, at least, the Bank of Canada’s resumption of interest-rate hikes seems to have prompted traders to capitulate to a certain degree: They are currently pricing in no change to the benchmark rate this year.

And bond yields, which signal the market’s longer term outlook for interest rates, are still near their highest in more than 15 years.

This change in market expectations could end up having a direct impact on the broader inflation outlook too, particularly in the housing market. Already there are signs that higher borrowing costs are squeezing out some buyers.

Part of that is because of the change in the fixed-rate mortgage market: Those loans are set off bond yields, so when the market expected interest-rate cuts were coming, borrowing costs for fixed-rate loans fell.

That was an important driver of the housing market’s spring surge. But now, with the market expecting rates to stay the same, the yield on Canada’s five-year government bond, which is the basis for a popular mortgage, has risen more than half a percentage point since the middle of April. This means mortgage costs are substantially higher than when prices were rebounding.

The number of homes trading hands still rose nationally in June, before the Bank of Canada’s second rate hike, though at a much slower pace than the previous two months, data released earlier this month from the Canadian Real Estate Association show. Prices for what did trade, however, continued to climb.

The types of mortgages people were getting offer a clue as to why these buyers might have been willing to bid so aggressively. During this year’s spring housing surge, more than half of home loans issued were for two- or three-year terms at a fixed interest rate, compared with the five-year mortgages that traditionally dominate the market, according to data from Statistics Canada. (Canadian mortgages are generally renewed at the end of a term, at the new market rate.)

This trend suggests many buyers are figuring that borrowing costs will fall sooner rather than later, and they’ll want the flexibility to take advantage if they do. It also suggests why there was such urgency this spring: If you think rate cuts are coming, a quarter-century of experience suggests it won’t be long before houses get more expensive.

“They want people to be convinced that we’re going to keep on raising it as much as we have to,” says William Strange, a professor at the University of Toronto Rotman School of Management who’s studied the psychology of real estate bidding wars. “How many times do you have to press the rate increase button to get that to happen? That’s hard to know.” BLOOMBERG