Carney massages market with message

Bank of Canada Governor Mark Carney deserves full marks for what he said while hiking interest rates by 25 basis points.

With a quarter-century of calling the markets under my belt, Tuesday's rate announcement by the central bank had to have been the most "dovish" press statement to accompany the inaugural rate hike of a cycle on record.

Before the rate hike, I had been pleading with the "Bank of Carney" to rethink its strategy of raising interest rates prematurely. My major concern was how one rate increase would be the trigger point for many more to come (it's the potato chip thing again - one is never enough).

Memo to Mr. Carney: Hold your fire on rate hikes Read David Rosenberg's earlier plea to Mark Carney

After all, on average, the Bank of Canada has raised rates 175 basis points over a 16-month span, and has never tightened policy by less than 125 basis points. (A basis point is 1/100th of a percentage point.) Central banks in general tend to always overdo do it in both directions - one of the reasons we get business cycles to begin with.

Recoveries start with aggressive rate cuts and recessions start with aggressive rate hikes. The experience of the past few years is a case in point, as the economy went from boom to bust and now back to boom again.

There is no disputing the impressive recovery in Canada, with 5-per-cent real growth (at an annualized rate) in the fourth quarter of last year, followed by a 6.1-per-cent pace in the first quarter of this year.

But we are still digging ourselves out of a deep economic hole and the economy is not in danger of overheating and generating inflation pressures. Most importantly, the European debt crisis and the ripple effects globally could end up being a replay of the Lehman collapse. Remember, the Bank of Canada raised rates in July, 2007, just as the financial crisis was getting under way. Why make the same mistake twice?

Besides, financial conditions have already begun to do the job for the central bank with corporate bond spreads widening materially and the stock market losing steam since the last time the Bank's policy team met in April.

However, to some extent, the Bank of Canada has boxed itself in. With having the markets fully discount a rate hike heading into Tuesday's meeting, it might have made the Bank look foolish to then suddenly do an about-face, current and prospective investor jitters notwithstanding.

What made Tuesday's rate action so interesting was, again, the press release. Go back and see what U.S. Federal Reserve chairman Ben Bernanke had to say in his opening salvo back in early 2006 - it was as hawkish as hawkish could be and he followed his initial tightening with several more.

Cat:e528746c-3414-401a-b14b-50247e3bdf01Forum:2d13dc33-9921-4d4a-815f-e809277631e4

By way of comparison, Mr. Carney was very balanced in his statement and seemed to guide the markets away from extrapolating this rate hike into future actions. He acknowledged that even with "considerable monetary stimulus in place" as well as the "the strength of domestic spending," the global economic recovery is "increasingly uneven," and there is still "significant excess supply in Canada" (a deflationary point I have been stressing). As a result, due to "… the considerable uncertainty surrounding the outlook, any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments."

That last comment was the one that really caught the attention of the marketplace. The Bank of Canada did raise rates, well-telegraphed though perhaps not well-timed in light of the current financial turbulence. But once again it used the press statement as a very important tool in terms of guiding investor expectations of where policy is headed.

Nearly everyone believed that a rate hike on Tuesday would be the launching pad for a series of further increases down the road. And why not? This has been the Bank's modus operandi for decades; raise rates till you can see the whites of the economy's eyes.

But Mr. Carney seems to understand the idea that we are still in the midst of in an intense global de-leveraging cycle, which is highly deflationary and can pose important roadblocks for a small open economy like ours. Given his ability to signal to the market that further rate hikes over the near term are not a sure thing, the Canadian bond market rallied in the aftermath of the policy meeting and at least one mortgage rate was cut even as the policy rate (and the prime rate) went up. So in some sense, the Bank of Canada tightened with its actions and eased with its words. This is why policy making, as I am sure Mr. Carney would attest, is as much an art as it is a science. Mr. Carney walked a fine line this week and did so adeptly. He also showed very clearly that he doesn't snack on potato chips.

David Rosenberg is chief economist and strategist for Gluskin Sheff + Associates Inc. and a guest columnist for Report on Business