Memo to Mr. Carney: Hold your fire on rate hikes

You know you're taking your life in your hands (well, reputation in any event) when you make an interest rate call with one day to go before what is arguably the most important Bank of Canada policy meeting in well over a year. In some sense, it seems like an easy forecast to make seeing as all the economists that toil for the Bay Street banks are forecasting a rate hike Tuesday and the money markets are almost priced the entire way for such a move.

The reason why everyone is bracing for the first interest rate increase the country has seen since July, 2007, is because the Bank of Canada purposefully set that universal expectation in motion when it decided not to drop the reference in its last post-meeting press release back on April 20, 2010, to its long-standing pledge to maintain its accommodative posture at least through to mid-2010.

A lot has changed since that time.

There is no doubt that the vast majority of economic releases before that last press statement, and since, reveal an economy that has sustained the rock-solid momentum so evident in that eye-rubbing 5-per-cent burst of GDP growth in the final three months of 2009. There is also no doubt that underlying inflation is a tad higher than the Bank of Canada thought it would be when it dropped the overnight rate to 0.25 per cent just over a year ago.

But much of the data digested by the central bank, the markets and economists are all backward looking and monetary policy should really be undertaken by looking through the front window as opposed to the rear-view mirror.

If you go back to the summer of 2007, you will see that the coincident indicators of economic activity were firm, but the leading indicators contained in financial market signals were telling central banks to cool their jets on any future rate hikes; think of the mistake it would have been for the Bank of Canada to have carried out any more tightening moves back then.

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Yes, yes, there is a case to be made that the current interest rate setting is at an "emergency" level and that the economy is no longer in need of such a huge degree of monetary stimulus. I buy that.

But, the problem with raising interest rates is that once a central bank embarks on that path, it's a tough task to talk the markets out of pricing in a whole cycle of increases. It's like eating potato chips - you can't stop at just one.

While I don't think anyone would want to detract from our economic achievements of the past year, we are still to a large extent digging ourselves out of a deep hole.

Even with the improvement in economic activity, real GDP is still more than 2 per cent lower today than it was two years ago at the peak and is actually no higher now than it was in the opening months of 2007. Think about that for a minute before we start to uncork the champagne over our economic progress - the level of real GDP hasn't budged in three years.

At the end of the day, the Bank of Canada's primary mandate is one of ensuring that the economy operates as close to price stability as possible. Last I looked, the unemployment rate was stuck at more than 8 per cent per cent, even with the improvement in labour market conditions. When all underemployment is included in the data, the unemployment rate is actually closer to 12 per cent.

Maybe this is why the Canadian wage rate - the 12-month change in average hourly earnings - has been shaved from more than 4 per cent a year ago to 2 per cent today.

The inflation rate is also comfortably below 2 per cent, as has been the case consistently since November of 2008.

Producer prices have deflated by more than 1 per cent in the past year and we have yet to see the full effects kick in from either the strong Canadian dollar or the recent downdraft in commodity prices.

Indeed, I remain of the view - and admittedly in the minority in this country - that the primary risk is one of deflation, not inflation.

A quick read of the FOMC minutes from the last Fed policy meeting shows that a growing number of policy makers south of the border are leaning toward this view as well. To wit: "Policy makers anticipated that both overall and core inflation would remain subdued through 2012 … participants noted several factors that likely would continue to restrain expansion in economic activity and posed some downside risks."

The Fed is willing to acknowledge the deflation risks as well as emphasize the downside economic risks, which is why it is likely not going to touch rates for a long while.

The Canadian economy does not operate in a vacuum and we are not isolated from global events, as we saw in 2008 and early 2009.

Even before the deflationary shock emanating from the European debt crisis, and even in the face of an economic rebound of its own, the Fed was stressing the need to maintain an accommodative policy stance because the future is highly uncertain - more than is typical coming out of recession - and that this recovery is more fragile than meets the eye and vulnerable to a policy mistake.

My hope is that the Bank doesn't make one as it did in 2002 when it last tightened prematurely.