Carney bound by macro forces

It can’t be easy being Mark Carney these days. With a mandate to keep inflation in check, the Bank of Canada governor should be facing an easy decision on interest rates Tuesday. But there are a lot of details outside of inflation he must contend with, according to a report from Desjardins Securities.

“In the first five months of 2011, the [Bank of Canada core CPI rate] has grown at an annualized pace of 3.8%, clearly above the top of the target range, compared to only 1.0% in the last five months of 2010,” writes Jimmy Jean, senior economist and macro strategist at Desjardins Securities. “There is little doubt that inflation pressures are escalating, and are not confined to temporary elements such as rising energy and food prices.”

At the same time, excess economic capacity seems to be drying up, reducing the economy’s ability to deliver on the higher demand that is driving inflation.

Jean suggests the Bank could raise rates to stem the rising tide of consumer borrowing, which has been a rational reaction to a prolonged period of record low borrowing costs.

“A rapid and sudden increase in interest rates would obviously put some households at risk of financial difficulties. Yet, the impact would probably be more manageable from a borrower’s perspective if interest rates were to climb gradually, enabling income growth to offset some or even the entire rise in borrowing costs.”

If the Bank were to continue its low-rate policy, it would run the risk of consumers indulging even further, making future rate increases even less palatable.

All of these reasons would make a rate hike a slam-dunk decision, if Canada existed in a vacuum. But there are strong forces beyond the control of the Bank that must be accounted for.

The primary argument against raising rates is the effect this policy would have on the Canadian dollar. The loonie is already soaring due to historically high oil prices, and the Bank is mindful of the impact that’s had on the manufacturing sector.

If the Bank’s overnight rate were to rise by more than 25 basis points, absent a matching rise in the U.S. Fed Funds rate, it would be outside a five-year differential band, and could attract foreign buyers.

“A 100-basis-point increase in the Canada-U.S. two-year yield spread could cause the Canadian dollar to appreciate to the tune of five to nine cents,” says Jean. “By comparison, through the last decade, this sensitivity has been for the most part less than three cents.”

The U.S. Federal Reserve is unlikely to raise its own rate before it at least starts to unwind its twin rounds of quantitative easing. Even that seems increasingly unlikely, as Fed Chairman Ben Bernanke recently suggested the Fed stood ready to further stimulate the economy, if needed.

Even the Canadian recovery is now in question, as the federal government and several provinces have announced austerity plans which will reduce both debt and GDP growth. In this environment, Carney will be under pressure to keep his foot on the accelerator.

“The BoC will likely remain patient and vigilant against risk factors that will probably remain elevated in upcoming months,” predicts Jean. “Whether we like it or not, the destiny of the U.S. economy will have a great influence on Canadian monetary policy.”

The Desjardins report predicts the Bank will raise rates by at most 50 basis points by next winter. Even that hinges on the U.S. economy posting strong growth in the second half of the year and the Fed warning that it may raise rates.

If the U.S. economy remains weak and the unemployment rate high, Canadians can expect Bank of Canada rate increases to come in lock-step with those of the Fed.

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.