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The rapid escalation of housing prices in the middle of a pandemic has alarmed many and so, not surprisingly, the calls for governments to act are getting louder.

A buffet of interventions, from eliminating the exemption on proceeds from the sale of a principal residence to the tightening of mortgage regulations, has started to surface.

Of course, the proper way to cool housing prices depends upon an informed prognosis of market conditions. Is the rapid increase in prices driven by market fundamentals, or is it a result of speculative bidding in a market where “animal spirits” are running loose?

Interest rates in Canada have steadily declined over the past two decades and that has put mortgage rates at historic lows, which can have two direct consequences. First, ultra-low mortgage rates reduce the borrowing costs for homebuyers such that their monthly mortgage payments are considerably reduced. Second, they cause upward pressure on pricing because these monthly mortgage payments are less affected by increasing prices than they would be at higher interest rates.

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Given the current circumstances, prospective homebuyers have two rational responses: Leave money (cheap debt) on the table and wait for a future where prices might be lower, but interest rates will be higher; or buy now to take advantage of the low interest rates.

Even if monthly mortgage payments are similar in high and low interest rate scenarios, a household’s long-term finances are impacted differently because a monthly mortgage instalment has two components: interest and principal.

With a high mortgage rate of five per cent or more, the interest component could consume more than two-thirds of the first monthly instalment, while the rest is dedicated to reducing the principal owed.

The balance between interest and principal reverses at lower interest rates. At a mortgage rate of, say, two per cent, the principal paid could account for two-thirds or more of the monthly instalment, and the interest accounts for the rest of the payment.

Will Dunning, a veteran housing economist, believes housing affordability has been improving over the past 15 years because homeowners can save more when principal payments account for a large share of the monthly instalment.

But although low interest rates improve affordability, some believe the recent rapid increase in prices is also a sign of irrational exuberance.

Sal Guatieri, a senior economist and director at BMO Capital Markets, said market fundamentals drive housing prices and demand. More buyers and fewer sellers have created a situation where prices have appreciated faster.

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Potential buyers can make two assumptions about the future when housing prices rapidly rise. They may believe that prices will continue to grow, and so the rational response will be to buy now rather than later. Or they may assume that the so-called bubble will burst soon, and they may stay on the sidelines waiting for favourable buying conditions.

As housing prices climb, many point to metrics such as the housing price-to-income ratio, which suggests a worsening of housing affordability. But the price-to-income ratio would only matter if homebuyers were paying the full price in cash. Most homebuyers borrow money to finance a house purchase. Therefore, the share of income consumed by housing costs might be a better metric to gauge affordability.

Either way, the unintended consequences of government interventions can often have lasting impacts. In the early 1970s, the federal government implemented the capital gains tax on the Carter Commission’s advice. An unintended and immediate consequence was the precipitous decline in the construction of purpose-built rental housing. More than four decades later, rental housing construction has never achieved the same heights as in the early 1970s.

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The same holds true for the supply of housing in general. In the 1970s, when the Canadian population was much lower than where it is today, far more housing was built. Since the mid-1970s, however, housing construction has been comparatively lower, even though the population has continued to increase.

If governments feel tempted to act, they should finally realize that residential construction in Canada has not kept pace with the population over the past five decades. Rather than hurt existing homeowners and current homebuyers with knee-jerk regulations, the three tiers of government should collaborate to address the chronic undersupply of housing.

Murtaza Haider is a professor at Ryerson University. Stephen Moranis is a real estate industry veteran. They can be reached at the Haider-Moranis Bulletin websitehmbulletin.com.