The Bank of Canada should raise borrowing costs within the next few months to show consumers and businesses that it has a grip on inflation, the Organization for Economic Co-operation says in a new assessment of Canada's economy.
Policy makers need not be aggressive in raising rates, as the reduction of fiscal stimulus, slower consumer spending as households pare record levels of debt, and a higher dollar will restrain economic growth this year, the Paris-based OECD says in the report.
Yet at 1 per cent, the Bank of Canada's benchmark lending target - the overnight rate for loans between private banks - is "highly stimulative," the OECD says in its biannual economic outlook for Canada and 33 other member countries.
The OECD considers a neutral benchmark rate for Canada to be between 4 per cent and 4.5 per cent, a highly academic target that nonetheless demonstrates how aggressive central bank Governor Mark Carney has been in fighting the financial crisis.
Canada's headline inflation rate was 3.3 per cent in April, faster than the central bank's speed limit of 3 per cent. While hotter inflation is mostly the result of a surge in food and energy prices, the OECD said there's evidence that expectations for higher future prices are starting to rise. That's important because the belief that inflation exists can become a self-fulfilling prophecy.
"Monetary policy remains highly stimulative despite indications that short-term inflation expectations have begun creeping upwards in recent quarters," says the report. "The Bank of Canada should therefore resume the normalization of policy rates soon in order to pre-empt a broadening of inflationary pressure."
The OECD predicted Canada's economy will expand 3 per cent this year, compared with its forecast of 2.3 per cent six months ago, and 2.8 per cent in 2012, compared with the previous estimate of 3 per cent.
Through a video link from the OECD's headquarters, Calista Cheung, the Canada desk officer, explained that the recommendation to raise rates "soon" means "within the next quarter," provided there are no dramatic changes to the overall economic outlook.
Ms. Cheung's urging for higher interest rates highlights a growing divergence between what experts think the Bank of Canada should do, and what investors think Mr. Carney will do.
On April 7, seven of 12 economists on the Toronto-based C.D. Howe Institute's shadow monetary policy committee, a mix of Bay Street analysts and academics that convenes ahead of each Bank of Canada policy decision, said the central bank should have lifted its benchmark rate to 1.25 per cent on April 12. All but one of the group's members said the overnight target should rise at the May 31 policy meeting.
But in financial markets, the sentiment is much different.
The odds that the Bank of Canada will increase interest rates by September last week sank below 50 per cent for the first time since March, Bloomberg News reported, citing an analysis of trading of overnight index swaps, which are financial assets whose value is linked tightly to expectations of future interest rates.
According to Bloomberg, the probably of a quarter-point increase by the Bank of Canada's Sept. 7 policy announcement dropped to 38 per cent last week after Statistics Canada reported that inflation eased in April from March. The odds were 55 per cent before the Statscan release, and as high as 75 per cent last month, Bloomberg said.
Royal Bank of Canada on Tuesday revised its outlook for interest rates, predicting Mr. Carney will opt against raising borrowing costs next week, dropping its year-end prediction for the overnight target rate to 1.75 per cent from 2 per cent.
Dawn Desjardins, RBC's assistant chief economist, told clients in a note that slower economic growth from the disruption to supply lines caused by the natural disaster in Japan and renewed worries about Europe's debt crisis will outweigh fears about future inflation.