(Adds detail from report)
OTTAWA, Nov 28 (Reuters) - The vulnerabilities created by Canada's high household debt and hot housing market remain elevated but should ease over time amid improving economic conditions and tighter mortgage rules, the Bank of Canada said on Tuesday.
In a more upbeat assessment of the risks facing Canada's financial system than six months ago, the central bank said continued demand and limited supply should support house price growth in Toronto and Vancouver, but higher interest rates and tighter rules will likely weigh on activity.
The closely watched report noted an improving labor market, especially employment growth, and said a moderate increase in mortgage rates would be "significant but manageable" for most borrowers. Canada's household debt hit record levels as buyers stretched to get into a roaring housing market.
"Our financial system continues to be resilient, and is being bolstered by stronger growth and job creation, but we need to continue to watch financial vulnerabilities closely," Governor Stephen Poloz said in a statement.
Suggesting the first steps in the right direction have been taken to lessen the vulnerabilities posed by debt and housing market imbalances, the bank said stricter guidelines for low-ratio mortgages - which take effect in January - should mitigate risks over time.
Still, the bank said a rise in the use of home equity lines of credit (HELOCs) may contribute to increased household vulnerabilities, especially if unemployment rises.
The report signaled the bank has taken some comfort in signs of improvement as regulators clamp down on lending, which could mean the housing market is less of a factor as policymakers consider further interest rate hikes.
The Bank of Canada raised rates twice in back-to-back moves in July and September but has since held policy steady, saying it would move cautiously as it assessed the impact of the rate hikes on the economy. Financial markets expect the bank to remain on hold until 2018, and then continue a tightening path.
The quality of new high-ratio mortgages, or those which involve a down payment of less than 20 percent, has improved, but there are signs of increasing risks associated with new low-ratio mortgages as highly indebted buyers shifted to different mortgage products as rules tightened.
While repeated government attempts to head off a housing bubble have caused some slowing of price acceleration in Vancouver and Toronto - which together account for about 50 percent of house sales by value in Canada - Vancouver is already rebounding and Toronto could follow suit, the bank said. (Reporting by Andrea Hopkins and Leah Schnurr; editing by Jonathan Oatis)