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Carney signals higher rates on the way Add to ...

For the first time in more than a year, Bank of Canada Governor Mark Carney is setting the stage for higher interest rates.

While a rate hike does not appear imminent, Mr. Carney is sending a clear message that borrowing costs will rise as soon the economy can handle it. Most observers now believe the next rate hike will be in September, a year after the last increase, and the central bank is likely to use its next rate decision on July 19 to signal its intentions.

When rates do rise, though, the central bank's language and economic realities suggest increases will be cautious and gradual.

"To the extent that the expansion continues and the current material excess supply in the economy is gradually absorbed, some of the considerable monetary policy stimulus currently in place will eventually be withdrawn," the central bank said Tuesday in Ottawa, as it left its benchmark rate at 1 per cent for a sixth time.

"Such reduction would need to be carefully considered."

Even though the economy has seen two successive quarters of impressive growth and increasing food and energy costs are causing inflation to exceed the target of the central bank, Mr. Carney is navigating a disconcerting plethora of foreign as well as domestic risks.

Policy makers indicated that on top of the dampening effect on exports from the Canadian dollar's "persistent strength," the fragile rebound in the United States is being held back as consumers there are squeezed by high energy prices.

And while Europe's recovery has momentum, risks linked to its debt crisis have escalated.

Domestically, growth is already slowing from a strong first-quarter performance and - perhaps most importantly - too many Canadian households are carrying debt loads that could engulf them if borrowing costs rise quickly.

That not only means Canadian consumers won't play much of a contributing role in the recovery, but also that Mr. Carney needs to tread carefully.

Indeed, a report by TD Economics released Tuesday includes some chilling numbers that bear out Mr. Carney's repeated warnings to households and banks about the dangers associated with keeping interest rates low for long periods of time.

For instance, with the benchmark rate still at an almost emergency-low level, the share of household income going to monthly debt payments is already at a two-year high. And as of the first quarter of 2011, more than 46 per cent of household debt in Canada was tied to the variable-rate products that are most sensitive to changes in the central bank's benchmark, up from 30 per cent at the beginning of 2009.

"Many Canadians will experience a financial shock when interest rates eventually rise, but the vast majority of households should be able to cope so long as interest rates only rise gradually," TD economists Craig Alexander and Diana Petramala said in the report.

Mr. Alexander, TD's chief economist, said in an interview that the precariousness of household finances suggest the central bank may not be able to raise rates to a level traditionally considered to be "neutral" - between 3 and 4 per cent - even after the economy is back at full strength.

Moreover, as long as the U.S. Federal Reserve is on hold, rate hikes in Canada would push the currency higher at a time when it is already poised to be above parity for years thanks to high commodity prices.

"They recognize that they're going to need to take back some of the monetary stimulus before long, and they'll do it once the risks have diminished," he said. "But I think the use of the word `some' is really telling you interest rates are not going up to what we would think of previously as normal levels. And that's a really important message for businesses and consumers." The central bank acknowledged that inflation in Canada has been faster than it was anticipating, but reiterated that both total inflation and the so-called core rate, which strips out volatile items like energy and fresh foods, will "converge" at the bank's 2-per-cent target by mid-2012.

That suggests the bank's view of when the economy will be firing on all cylinders has not changed from a forecast released in mid-April, which said this would occur around the middle of next year. Economic theory holds that Mr. Carney must bring borrowing costs to a neutral level by then or risk losing his grip on price gains.

But economists say factors like the currency and Canadians' indebtedness are already putting a brake on growth, as exporters struggle to compete with new rivals and households cut back on spending. As a result, Mr. Carney has more time to assess the arguably scarier risks from abroad, which are always paramount to an export-dependent economy.

"They're not jumping into this normalization aggressively because they're still operating in a very, very uncertain environment," said Geoffrey Somes, a senior economist with State Street Global Advisors in Boston. "The global economy remains a pretty dangerous place."

 

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