Canada’s rate hikes will be tied to the Fed

Canada’s rate hikes will be tied to the Fed

December 29, 2009 – Updated: December 29, 2009

When the Canadian dollar topped 95 cents (U.S.) last week, approaching a three-week high toward the end of a year that has seen the currency gain 16 per cent against the U.S. dollar, it deftly illustrated the biggest influence on what will be Mark Carney’s most crucial decision of 2010.

 

 

As economists and investors debate with increasing vigour about when the Bank of Canada will raise interest rates from their current rock-bottom level, the effect such a move could have on the loonie may mean borrowing costs have to stay where they are well into the recovery. The central bank chief pledged last April to keep his main interest rate at the record-low level of 0.25 per cent until at least June, 2010, in order to stimulate enough borrowing and spending to solidify the economy’s recovery. The resulting ultra-cheap mortgages spurred a buying spree in housing, and by the fall, Mr. Carney was stick-handling around endless talk – from just about anywhere other than the central bank – of a potential asset bubble in residential real estate.

 

While saying the white-hot market was a result of pent-up demand from Canadians who had put off purchases during the worst days of the recession, Mr. Carney finished the year warning people to avoid taking on more debt than they would be able to handle when interest rates go up again, as they inevitably will.

 

Finance Minister Jim Flaherty, albeit indirectly, poured some cold water on the notion that Mr. Carney would raise borrowing costs before mid-2010 to cool the housing market; in interviews last week, Mr. Flaherty noted he is prepared to take steps of his own if necessary, such as increasing the minimum down payment on a home and shortening the maximum length of mortgages.

 

But even as the central bank characterized its concerns about Canadians’ debt loads as a low risk to spread through the financial system, Mr. Carney emphasized throughout December that his commitment to wait until next June before tightening monetary policy was very much conditional on the outlook for the bank’s 2-per-cent inflation target.

 

“I’m not worried that we’re in a box, because if things change we would change policy as appropriate,” Mr. Carney told BNN in a year-end television interview that aired Dec. 17. “We have the flexibility to adjust it, either by shortening or lengthening [the waiting period], if that’s what’s necessary to achieve our mandate.” And that’s where the loonie comes in.

 

To keep the housing sector in check, Mr. Carney can do little more than manage expectations for a rate hike that will come eventually, at a time of his choosing. That’s in part because inflation is still below the bank’s target.

 

It’s also because with borrowing costs so low in most of the world’s major economies, raising interest rates would make Canada a more attractive place for international investors seeking higher yields, which could send the Canadian dollar soaring. That would further complicate life for exporters trying to regain a footing in global markets that are still smarting from the downturn.

 

“Given the remarkable homogeneity of monetary policy around the world, you really do risk being that tall poppy and getting hit quite hard by the currency,” said Eric Lascelles, a strategist at TD Securities in Toronto. Mr. Lascelles pointed to the recent example of Australia, another commodity-based economy, where the currency soared against the U.S. dollar after that country’s central bank became the first in the Group of 20 nations to raise interest rates in early October.

 

Last Thursday, the Canadian dollar appreciated 0.8 per cent in part because investors had started to become more convinced the central bank was merely considering a rate hike before mid-2010 or, at the very least, before the U.S. Federal Reserve, which many investors see keeping rates near zero into 2011. That has helped the loonie outperform its major counterparts this month.

 

The Bank of Canada, which will update its forecasts during the week of Jan. 18, currently maintains it could even take until the third quarter of 2011 for inflation to return to 2 per cent and for the economy to be running at full tilt, largely because of the currency’s drag on sales of Canadian goods abroad.

 

Some analysts are painting Mr. Carney’s assessment as too cautious.

 

“Both growth and inflation risks lie north of the Bank of Canada’s current forecasts,” Yilin Nie and David Cho, strategists at Morgan Stanley in New York, wrote in a recent research report. “We believe the bank will need to hike before its conditional commitment to keep rates low until June, 2010, and before the Fed. Our forecasts show the first Bank of Canada rate hike in April, 2010.”

 

Most Canadian economists, meanwhile, remain in wait-and-see mode.

 

Michael Gregory of BMO Nesbitt Burns in Toronto wrote in a Dec. 18 note to investors that he sees “increasing risk that the policy rate renormalization process will kick off soon after Canada Day, with a small but not small-enough-to-ignore possibility that the first action could occur even earlier.”

 

At the opposite extreme, however, are those who believe Mr. Carney will wait until late next year, or even later, to tighten – not least because the effect on the currency could be too severe should the Bank of Canada’s benchmark rate be lower than the Fed’s for more than a few months.

 

“The Bank of Canada will think very, very hard before raising interest rates ahead of the Fed,” said Benjamin Tal, a senior economist at CIBC World Markets in Toronto, who predicts a slow U.S. recovery will keep the Fed on hold and force Mr. Carney to wait until the first quarter of 2011, when the rate will jump to 1 per cent. “To an extent, not fully but to an extent, monetary policy in Canada is being highly influenced by developments in Washington.”

 

Mr. Lascelles of TD Securities said the Fed won’t abandon its unprecedented stimulus until early 2011, with the Bank of Canada therefore waiting until the fourth quarter of 2010, even though Canada’s economy is poised to heal more quickly than that of the United States. The bank can and probably should hike rates before the Fed because of stronger fundamentals, but it really is quite restricted in terms of how much sooner it can go.

 

While the image of the central bank being held captive to the Fed might bring shudders to Canadian nationalists, Martin Coiteux, an economist and professor of international business at HEC Montreal who has tracked monetary policy in both countries, said the notion is overblown.

 

First, the effect on the currency of the difference between Canadian and U.S. borrowing costs are, historically, just a few months, he said. And even as Mr. Carney worries about hurting exporters any more than they’ve already been hurt, if the domestic spending he has stoked in the housing sector catches on enough to raise prices throughout the economy, he’ll have no choice but to raise rates, regardless of the Fed.

 

“[The Bank of Canada’s] main objective is to keep inflation between 1 and 3 per cent per year, with the target being at 2 per cent,” Mr. Coiteux said. “We might be going up very gradually toward 2 per cent, but as we move there, in order to keep their credibility, they’ll have to move, too.”

 

 

 


Source:  CTV.ca

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