OTTAWA -- The Bank of Canada used record-low interest rates to help save the economy and put it back on the road to growth. But in doing so it might have created a bigger headache down the road with Canadians carrying too much debt.

The central bank acknowledged as much on Thursday in the latest edition of its financial system review, in which it suggested the risk posed by rising household debt levels to financial market stability has increased.

Canada’s debt-to-income ratio had climbed to a new high of 142% as of the end of June, in part because consumers are rushing to take advantage of low borrowing costs to buy up assets. Nowhere is this more evident than in the housing market, where the average price of an existing home is up 21% from a year ago while sales volume has climbed 41%.

But in taking on new debt, consumers may be failing to account for higher interest rates in the foreseeable future, leaving households “increasingly vulnerable” to any economic shocks, the central bank indicated.

“What the Bank of Canada is saying is that there might be too much of a good thing going on,” said Benjamin Tal, an economist at CIBC World Markets. “And I think the issue here is to what extent are extremely low interest rates are blinding Canadians, and giving them a false sense of confidence to buy a bigger house.”

Graham Withers, a film and TV editor in Toronto, said the Bank of Canada’s warnings are justified. He and his wife, Heather Harding, just bought a house -- but not after nearly a half-dozen failed bids in the past month in which properties sold for at least 20% over asking price.

“It was kind of disappointing in the beginning because we were careful not to stretch ourselves further than we could handle,” Mr. Withers said. “Our search felt really irrational, at times, in terms of bidding. Just because money was available to people, it seemed that was artificially inflating the price of houses.”

Finance Minister Jim Flaherty picked up on the Bank of Canada’s warning, saying on Thursday the government is monitoring household debt levels, and could introduce regulatory changes that would make it more difficult for Canadians to get mortgage insurance -- a key condition required before banks agree to extend financing for a home purchase.

“We certainly want people to be careful because interest rates are very low now and there’s lots of liquidity in the system. There’s lots of money being lent and I do ask Canadians to be mindful of the fact that interest rates will not be low indefinitely,” Mr. Flaherty told reporters.

The central bank’s review is a semi-annual publication, and is meant to highlight the downside risks that could cause stress in the financial markets, even if they are low-probability events.

Three of the five risks had decreased over the past six months, and one remained unchanged. But the peril posed by ballooning household balance sheets increased, which is directly a consequence of the central bank keeping its benchmark interest rate at near zero, or 0.25%, in an effort to pump up the economy after a deep recession.

“The medium-term risk to financial stability arising from the household sector is judged to have increased,” it said. “This judgment is predicated on concerns that the sustained growth of household debt in the context of rising interest rates will increase the vulnerability of households to an adverse shock over the medium term.”

To illustrate its point, the bank conducted two hypothetical tests, whereby in one scenario interest rates rise to levels consistent with expectations in the fixed-income market, while in another rates climb at a faster pace than market expectations.

The results, for the period up to the second quarter of 2012, suggest the proportion of households with high-risk debt service ratios -- the amount of income required to repay loans -- would climb to a record level, regardless of scenario. Even in the gentler test, where the benchmark rate goes from 0.25% to 3.2% in June 2012, the percentage of high-risk households rises to 8.5% from the present level of 6%. In comparison, the historical peak was 7.4%, reached in 2000, whereas the average over the past decade was 6.1%.

Analysts expect the Bank of Canada and its governor, Mark Carney, to speak more in coming months about the household debt risk in an effort to persuade Canadians, and lenders, to exhibit more prudence. Further, highlighting the risk might set the groundwork for rate hikes later this year, after its conditional pledge to keep its target rate of 0.25% intact until June 2010. That pledge is pegged on inflation returning to its preferred 2% target in mid-2011.

“The fact that they are signalling this is a cautionary tone for people to heed,” said Michael Gregory, senior economist at BMO Capital Markets.

National Post

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