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Higher borrowing costs on horizon: Carney Add to ...

Mark Carney has put borrowers on notice that he is not afraid to raise interest rates even in the face of global turmoil, if that is what it takes to keep hotter-than-expected inflation under control.

The Bank of Canada governor left his benchmark rate at 1 per cent, pointing to threats on both sides of the Atlantic and a still-sluggish performance for Canadian exports because of the strong dollar and soft U.S. demand. But, after staying on hold for a seventh consecutive time, he all but eliminated any doubt that borrowing costs will rise this year, sooner than many market observers had come to expect.

Most economists see the overnight rate climbing by 75 or 100 basis points in the next year, which would bring it to 1.75 per cent or 2 per cent, as the central bank proceeds with caution and keeps one eye on foreign developments. Those moves would be felt most by Canadians with variable-rate mortgages and other floating loans, and the central bank has fretted that many households will have trouble carrying the debt they’ve piled up as interest rates rise. As a result, economists say it’s very unlikely Mr. Carney will hike aggressively.

With the U.S. Federal Reserve holding the line on rates near zero for the foreseeable future, any Bank of Canada hikes would widen the gap with the U.S. and fuel the already surging loonie, causing more grief for exporters. The Canadian dollar jumped 0.88 of a U.S. cent Tuesday to $105.17, the highest level since April.

“The base case is very modest and parsimonious hikes, depending on the flavour of the day and how things evolve,” said Sébastien Lavoie, assistant chief economist at Montreal-based Laurentian Bank Securities and a former Bank of Canada economist, predicting an increase as early as the next decision on Sept. 7 and a benchmark rate of 1.75 per cent by mid-2012.

Nonetheless, in a teaser to a full forecast due Wednesday in Ottawa, Mr. Carney painted a picture of a domestic economy that is more than holding its own amid a range of global risks, and implied that inflation would need to be addressed soon.

The central banker left himself room to manoeuvre, saying his outlook assumes authorities in the euro zone can contain the continent’s debt crisis and acknowledging there are “clear risks around” such an outcome.

But by tweaking his announcement at Tuesday’s decision to say, “some of the considerable monetary policy stimulus currently in place will be withdrawn” – instead of “eventually withdrawn,” as in his May 31 statement – Mr. Carney made clear that if things don’t worsen, he will use at least one of his three remaining decisions in 2011 to tighten policy.

“His main mandate is to keep the cost of living advancing by 2 per cent, and you have to go with the base-case scenario that nothing goes wrong in Washington and nothing goes too wrong in Europe,” Mr. Lavoie said, noting the bank didn’t mention U.S. debt-ceiling negotiations, suggesting it believes they will be resolved before the Aug. 2 deadline.

“Markets assumed the bank thought the risk of hiking was perhaps greater than the risk of staying on the sidelines, but now the picture has changed, and the bank is showing its inflation-fighting credentials.” Indeed, Mr. Carney and his deputies said even as “widespread concerns” over sovereign debt problems have “increased risk aversion and volatility in financial markets,” financial conditions in Canada “remain very stimulative” and the growth of private credit is strong.

The central bank barely touched its growth projections for Canada from 2011 to 2013, and said the preferred gauge of inflation, which is approaching its 2-per-cent target sooner than predicted, will hover around that level through 2013. Significantly, the bank also left untouched its prediction for the so-called output gap – essentially, a measure of the slack left in the economy by the recession – to be closed by mid-2012.

By not pushing the timing further out, policy makers signalled that global risks, while worrisome, are not having enough impact on Canada to throw the domestic rebound off course.

On consumer prices, after saying for months that both total inflation and the “core” rate – which strips out volatile items like gasoline and fresh foods – would converge around 2 per cent around mid-2012, the bank conceded that core inflation, at 1.8 per cent in May, is rapidly approaching that level already.

In addition to the caveat about Europe, whose leaders are scheduled to meet Thursday in a bid to break an impasse over a new rescue for Greece that has roiled markets, Mr. Carney acknowledged that the recovery in the United States –Canada’s chief export market – has been held back as consumers tighten their belts and the world’s biggest economy fails to produce a meaningful number of new jobs.

Some economists suggested that a rate hike is more likely in October or December than in September, since the European debt saga could easily still be playing itself out later this summer, and because it will take a while for evidence to materialize that the Canadian rebound picked up in the second half after a dismal second quarter.

Angelo Melino, an economics professor at the University of Toronto who sits on the C.D. Howe Institute’s shadow monetary policy council, said the central bank struck the right balance between reassuring investors and economists that it will not let inflation get out of control, while giving itself an ‘out’ should conditions deteriorate.

To Prof. Melino, Mr. Carney’s statement marked a notable shift from the past few months, when observers had started to openly question whether the central bank was putting too much emphasis on risks that might not materialize, even as the domestic economy gathered momentum.

“They sent a signal to the markets that tightening could occur if all of these various financial-sector risks aren’t realized, and things proceed as their best guess suggests they will,” Prof. Melino said. “They still are putting a lot of emphasis on tail risks, but this statement balances things again.’’

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