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Bank of Canada Governor Mark Carney.


The argument against ultralow interest rates tends to be reduced to inflation and asset-price bubbles.

But there are other reasons to worry about where current monetary policy could be leading us.

Could the inability to earn a profit from government bonds cause insurance companies to adopt the riskier habits of investment banks? Have central banks unwittingly made it even harder from smaller companies to raise capital by creating an environment that favours big, dividend-paying corporations? Is the Bank of Canada's benchmark interest rate of 1 per cent allowing provincial finance ministers to avoid getting serious about their strained finances, and floating weak companies that otherwise would go under?

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Paul Masson, one of Canada's leading financial economists, lists all those risks – along with the more common spectres of runaway inflation and bubbles – in making the case that the time has come for the Bank of Canada to change course.

"The cumulative effect of artificially low interest rates on the economy increasingly will show up in pervasive distortions of economic decisions, and risk fuelling an underlying inflationary process," Dr. Masson, a PhD economist who has worked at the Bank of Canada and the International Monetary Fund, writes in a paper published Wednesday by the C.D. Howe Institute.

"Therefore, the Bank of Canada should start now to reverse some of the monetary stimulus and begin raising interest rates."

The Bank of Canada's benchmark interest rate – the overnight target for loans between commercial banks – has been 1 per cent or lower since January 2009.

Never in the central bank's history have borrowing costs been so low.

Policy makers dropped the benchmark rate to 0.25 per cent to endure the financial crisis, and raised it to 1 per cent in September 2010. There central bank's current guidance suggests it intends to leave the overnight target untouched for at least the rest of the year. The central bank hasn't left interest rates unchanged like that since the 1950s.

Dr. Masson's call for higher rates is a challenge to the complacency that has come to characterize the debate over Canada's monetary policy.

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Bay Street economists tend to dismiss the Bank of Canada when it says its next interest-rate move – whenever it comes – will be to take rates higher. Dr. Masson's paper helps explain why Governor Mark Carney has resisted a tilt to neutral, even as the economy struggles to gain momentum.

In fact, many of Dr. Masson's arguments for higher rates are lifted from the Bank of Canada's Financial Stability Report, its twice-a-year assessment of the financial system.

Like the Bank of Canada, Dr. Masson worries that too many households that would be unable to finance their recently purchased homes at higher interest rates will be in trouble when borrowing costs inevitably rise.

Also like the Bank of Canada, Dr. Masson sees the potential for trouble in the insurance industry, which is suffering tremendous collateral damage from central banks' efforts to stoke the broader economy.

Insurance companies must offset their liabilities with investment income, traditionally done rather safely by purchasing government bonds. Because yields on sovereign debt now are so low, insurers' profit margins are shrinking, creating an incentive to purchase riskier assets.

Dr. Masson sees many other reasons to be wary. Bubbles could be forming in prices of real estate investment trusts and high-dividend-paying stocks. As of the end of February, for example, indexes that track such assets had risen by as much as almost 10 per cent, even as the S&P/TSX Composite Index essentially was flat.

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The rush to dividend-paying stocks – the closest thing investors have to a safe investment that also generates a little income -- also could be hurting smaller companies, which typically reinvest their earnings.

Dr. Masson notes that the S&P/TSX Small Cap Index fell 16 per cent between February 2012 and February 2013. This has broader economic implications because smaller companies tend to grow faster and hire more people than established corporations.

Dr. Masson also argues that low interest rates could be impeding important structural changes by allowing "zombie" companies to obtain cheap financing, and allowing debt-heavy provinces such as Ontario and Quebec to avoid the "hard choices" needed to get their budget deficits under control.

While aware that its interest-rate policy carries the risk of unintended consequences, the Bank of Canada has decided the possibility that higher borrowing costs would choke already weak economic growth is the greater threat.

Sluggish growth is keeping a lid on inflation. Higher interest rates quite likely would put upward pressure on the currency, which already is trading at a level that the central bank says is hurting Canadian competitiveness.

Dr. Masson acknowledges that the currency is a concern.

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But he thinks Canadian exporters could handle a modest appreciation because the steady recovery of the U.S. economy promises steadily stronger demand.

"Although one would not want to push them up sharply, there is some room for raising rates," he writes.

It is unlikely Canada's policy makers will be persuaded. The trend among central banks is to either lock in at low rates or to lower them.

Canada's economy would have to strengthen significantly to prompt the Bank of Canada to go against the grain.

However, Dr. Masson's work won't go unnoticed at the central bank. Anyone who wonders why the Bank of Canada insists that it wants to raise interest rates as soon as possible need only read Dr. Masson's paper.

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