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taking stock

When veteran economist Brian Bethune looks back at the global financial train wreck of 2008, two wrong-headed moves by central banks stand out. And the Bank of Canada may be about to turn the tone-deaf duet into a trio.

The European Central Bank (ECB) decided on July 3, 2008, to boost interest rates by a quarter of a point to 4.25 per cent, close to a seven-year high. And officials let it be known that even though several euro-land economies were struggling, they would jack up rates even further if they didn't like the inflation trend. The euro soared, and the region has yet to recover from the fallout.

Then, the next month, with inflation edging above its comfort zone, the Federal Reserve indicated that the next time it adjusted its key rate, it would be heading up.

We know what happened next. Within weeks, an already teetering Lehman Brothers plunged into the abyss, credit markets seized up and the global economy cratered. The Fed would soon discover that 2-per-cent interest rates were about 2 per cent too high. And the inflation-fixated ECB would belatedly realize it had been wrong.

Now, the Bank of Canada can make it a trifecta if it opts for any serious rate hikes in the coming months, argues Mr. Bethune, the newly minted chief Canada watcher for IHS Global Insight.

"There is absolutely no rationale for any premature tightening in this environment," he says. "Things are still fragile. Any sudden shock, an upward movement in interest rates, could be devastating for this recovery."

The central bank ought to be paying close attention both to the effects of the rising Canadian dollar and to what's happening south of the border, Mr. Bethune says. Tightening policy ahead of the Fed could drive the loonie well above par and exacerbate the woes of Central Canada's battered manufacturing sector.

An Investor's Guide to Understanding the Economy by Gary Rabbior:

  • Part 1: How the money in the economy is managed
  • Part 2: How inflation works
  • Part 3: Avoiding the deflationary spiral
  • Part 4: How much money is too much money?
  • Part 5: How markets and currencies work
  • Part 6: How interest rates affect your investments

The subject has come up, because Mr. Bethune doesn't like what he hears from the government (which seems to have decided a strong Canadian dollar is benign) or Bank of Canada chief Mark Carney, who pledged last spring to leave the benchmark interest rate at its rock-bottom level until at least mid-2010, depending on the bank's inflation assessment.

Last week, Mr. Carney declared that "core inflation has been slightly firmer than projected." He acknowledged the bump stems partly from such temporary phenomena as the high prices forced upon visitors during the Winter Olympics. But Mr. Carney pointedly added that stronger economic activity has also been at play.

Nothing prevents the bank from sitting on its hands for the rest of the year. But Mr. Bethune fears our banker-in-chief has painted himself into a tightening course that will gain a further boost from a strong first quarter for GDP.

The dollar's appreciation already amounts to "an effective tightening. And that message has to get across to people. You can't just pretend it [a stronger dollar]doesn't have consequences. So the question becomes: Do you want to fan the flames even further by raising interest rates?"

He estimates the loonie could be at or above parity before the end of this quarter, so this is no idle question.

And don't get him started on inflation, much of which he attributes to higher commodity prices stemming from demand in fast-growing emerging economies.

"That's not something that's in the control of the Federal Reserve or the Bank of Canada. So why would the industrialized countries slow down their economies to achieve a rate of inflation that is artificially low ... It does not make sense."

Mr. Carney's task is to separate "the transitory effects on both [economic]growth and prices from the Olympics from the underlying reality that there's huge excess capacity in the North American economic space," which drastically reduces the risk of inflation.

But it wouldn't be the first time an Olympic lift has affected central bank policies.

Back in 2008, the ECB overreacted to a spike in oil prices triggered by Chinese hoarding of diesel fuel in advance of the Summer Olympics. "Will the Bank of Canada make a similar mistake because people snapped up $8 hot dogs at the [Winter]Olympics?"

Meanwhile, the Canadian picture is clouded by the uncertain U.S. outlook.

The U.S. jobless rate of just under 10 per cent underestimates the enormous slack in the American economy.

Mr. Bethune still wears his old hat as IHS Global Insight's chief U.S. financial economist, but the Ontario native's Canadian roots run deep. Dr. Norman Bethune was his great-great uncle.

His advice to Mr. Carney: "I would recommend steady as she goes. But now that they've made so much noise about it, they may have to make a couple of token increases to maintain their credibility."