Rate hikes coming, but pace will be slow

(June 24, 2004) The U.S. Federal Reserve will raise interest rates next week, leading the Bank of Canada to tighten credit as well, Canadian bank economists. But the long-term pace of rate increases should be fairly slow.

“The economy is now doing well enough on the employment front that the Fed feels comfortable reducing the stimulus to the system,” says Avery Shenfeld, managing director and senior economist at CIBC World Markets. “There’s still some fragility in the economy, because employment is only just getting going.”

Shenfeld says the expected 25 basis point rate hike is not so much of a braking maneuver, than an easing off of the accelerator. Any move to raise rates quickly could hurt the heavily indebted consumer sector, which so far has been incredibly resilient.

“The pace at which the Fed can move back to the more historically normal interest rate of 3% to 4%, is going to be restrained by the drag that move will pose on the household sector.”

Economists at TD Bank agree, calling for a quarter-point hike to be delivered on June 30, with rates rising by a full point by the end of the year.

“With the U.S. economy running in high gear and the Canadian economy revving up, central bank rate hikes are in the pipeline,” said Don Drummond, senior vice-president and chief economist at TD Bank Financial Group. “However, the tightening in monetary policy will be gradual, which means that interest rates will remain highly stimulative to economic growth and supportive to financial markets for the rest of this year.”

But Canadian rate hikes are not likely to follow too quickly, according to Warren Lovely, senior economist at CIBC World Markets. He suspects the Bank of Canada will not raise rates at its July meeting, preferring to wait until September for a tightening move.

“We are entering a rising rate environment and while rates are poised to go higher on both sides of the border, rates likely won’t rise as quickly as the market currently fears,” says Lovely. “The Bank of Canada is likely to move more gradually than the Fed in the U.S.”

He says the spread between U.S. and Canadian interest rates will narrow and probably invert by the end of next year, meaning American interest rates will be higher. As a result, upward pressure on the Canadian dollar would be alleviated.

“The Bank of Canada will intentionally allow that spread to evaporate, really to prevent another outbreak of significant ‘C-dollar’ strength,” says Lovely. “We think the Bank of Canada would much prefer to see narrower spreads and a weaker Canadian dollar, as opposed to generous spreads and a rapidly appreciating Canadian dollar.”

The dollar should settle into a sustainable range of 73 to 75 cents US, he says, while the rapid appreciation seen earlier in the year may yet have an impact on the export sector. Rather than a risk of inflation, the economy could still slow from its second-quarter growth rate of 4%.

“We don’t expect core inflation to get back on a sustained basis to the Bank of Canada’s 2% target until well into next year,” Lovely says. “In the absence of a core inflation threat, the Bank of Canada will have the luxury of moving a bit slower than the Fed in terms of raising interest rates.”

TD’s Drummond predicts the Bank of Canada will raise rates by a total of 75 basis points by the end of 2004, with another 75 points being tacked on throughout 2005.

“This tightening of monetary policy will not pose a threat to the economic expansions in Canada or the United States,” he said. “Rates are currently at such low levels that the gradual increase means that borrowing costs will remain at well below their historic norm.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com