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if the Bank of Canada continues its custom of increasing rates in increments of 25 basis points, then going from the current level of 1 per cent to 3 per cent would require 8 increases in the next 10 interest rate decisions. (Sean Kilpatrick/SEAN KILPATRICK/THE CANADIAN PRESS)
if the Bank of Canada continues its custom of increasing rates in increments of 25 basis points, then going from the current level of 1 per cent to 3 per cent would require 8 increases in the next 10 interest rate decisions. (Sean Kilpatrick/SEAN KILPATRICK/THE CANADIAN PRESS)

Economy Lab

Interest rate hikes are coming - and soon Add to ...

This is the passage in the Bank of Canada's Monetary Policy Report that attracted most of my attention yesterday:



"On an average annual basis, real GDP is projected to grow by 2.9 per cent in 2011 and 2.6 per cent in 2012, while growth in 2013 is expected to equal that of potential output (2.1 per cent), with the economy operating at full capacity. This growth profile implies a slightly higher level of activity across the medium-term projection horizon, with the Bank now expecting the economy to return to full capacity around the middle of 2012, two quarters earlier than had been projected in the January Report."

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My post on the March 1 interest rate decision noted that the 'output gap' -- the difference between actual output and potential output -- plays a key role in how the Bank conducts policy. When output is below potential, interest rates are kept low to make sure that inflation does not fall below its 2 per cent target. When output is at potential -- that is, at the level where there are no pressures on inflation in either direction -- the Bank sets interest rates at a 'neutral' rate, which is widely believed to be between 3 and 4 per cent. In March, it was estimated that the closing of the gap was roughly 22 months away, at the end of 2012.



Six weeks later, the news that the gap is now expected to close in mid-2012 shortens the horizon to 14 months or so. If the Bank continues its custom of increasing rates in increments of 25 basis points, then going from the current level of 1 per cent to 3 per cent would require 8 increases in the next 10 interest rate decisions.



There are many reports that financial markets are expecting the Bank of Canada to wait until July 19 before increasing interest rates. It's not clear to me why it would or should wait until then. In the opinion of the economists on the CD Howe Institute's Monetary Policy Council -- which called for in interest rate increase in January, March and again in April -- the Bank has already waited long enough.



It is likely that the Bank's reluctance to increase rates this time was in large part based on a desire to keep a low profile during the election. But after the election, financial markets should be preparing for a sustained round of interest hikes, and for it to start before July.



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