Central bank hikes rates

(September 7, 2005) The Bank of Canada today raised its key overnight lending rate 25 basis points to 2.75%. The increase was expected, but economists are now debating whether the central bank will continue raising rates, given the effects of Hurricane Katrina.

The bank had not changed its interest rate since October of last year. “With the economy operating close to full capacity, today’s interest rate increase will help to promote a balance between aggregate demand and supply in the economy and keep inflation on target over the medium term,” the bank said in statement, adding that the economy has evolved in-line with expectations, with the notable exception of a spike in energy prices.

“Hurricane Katrina has taken a tragic human toll in the U.S. Gulf states,” the bank said. “The bank’s preliminary assessment is that the hurricane’s disruption to the U.S. economy is likely to translate into somewhat lower output growth in the United States over the balance of 2005 and somewhat higher growth in 2006.”

The U.S. Federal Reserve has raised its key lending rate at its last 10 meetings, pushing the rate up to 3.5%. Those moves were justified because the price of oil was being driven up by strong world demand, says Clement Gignac, chief economist at National Bank Financial. “However, uncertainty about the destruction of U.S. production and refining capacity has transformed a demand shock into a supply shock. In these circumstances we believe caution is in order. We expect a pause in monetary tightening.”

Still, the Bank of Canada said in its statement that the “overall impact on Canadian economic activity will probably be modest, although there will be a temporary spike in consumer prices, reflecting higher prices for gasoline and heating fuels.”

BMO Nesbitt Burns chief economist Sherry Cooper interprets that to mean that the central bank is keeping its options open for its next rate decision in October, though she still expects another increase, depending on economic data.

“The bank will surely want to continue pushing rates higher,” adds TD economist Carl Gomez. “But the unusually large amount of uncertainty in the economic outlook also suggests that the bank will want to see how the U.S. economy fairs over the next few months and whether the recent spike in energy prices proves to be transitory. As such, we think the bank has left the door open for a pause in October, but a rate hike would follow in December.”

Following the Bank of Canada’s announcement on Wednesday, the big banks bumped up their prime lending rates a quarter-point to 4.5%. Variable mortgage rates are also expected to rise.

Filed by Doug Watt, Advisor.ca, doug.watt@advisor.rogers.com