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A new bump on Mark Carney's road to higher rates

The Bank of Canada will probably leave its benchmark interest rate at 1 per cent for a sixth consecutive decision on Tuesday, and with Finance Minister Jim Flaherty saying that he's "quite worried'' there might be another global recession, who could blame Mark Carney for concluding yet again that it's better to err on the side of caution?

At this point, the smart money seems to be on there being no move before September or October. Derek Holt of Scotia Capital, an analyst with a particularly solid track record of prescience, says Mr. Carney, the Bank of Canada Governor, might even stay on hold into 2012, predicting a series of "rolling fiscal shocks'' that will keep central bankers on the sidelines in many advanced economies.

"We're by no means out of this just yet,'' Mr. Holt said last week.

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So forget about getting a clear signal Tuesday about an imminent rate hike.

Investors and the Bay Street economists who are paid to guide their thinking had already given up on that idea earlier this month, when a gloomy-sounding speech by Mr. Carney lowered expectations.

Regardless, most of the academic experts who pay closer attention to models and theory than to the twists and turns of on-the-ground economic data continue to insist that Mr. Carney could lose his grip on inflation if he doesn't start tightening - and soon.

Their argument boils down to this: Since the central bank predicts the economy will be back at full tilt in mid-2012, borrowing costs should be at a so-called neutral level by then or else there will be excess demand in the economy that causes inflation to get out of hand.

Historically, that neutral sweet spot has been a benchmark rate between 3 per cent and 4 per cent. The Organization for Economic Co-operation and Development, which last week said the Bank of Canada needs to do at least one rate hike in the next few months to demonstrate to consumers and businesses that it's on the case inflation-wise, considers neutral to be as high as 4.5 per cent.

Either way, it's a far cry from 1 per cent. Unless, of course, the "new" neutral is not as high as the "old" neutral.

Expectations that rates would climb started to be whittled away almost immediately after Mr. Carney's mid-May speech in Ottawa, in which he hinted he is increasingly worried about the impact that soaring commodity prices are having on U.S. demand for other exports, at a time when the currency and competitiveness issues are already holding back Canadian companies' fortunes. Then there's Europe's worsening debt crisis, the possibility that still-loose monetary policy in emerging markets will cause some of the world's biggest economies to overheat, and the temporary but significant effects of Japan's natural disasters on global supply chains. Add in the coming deficit-cutting in Canada, eventual belt-tightening in the United States that will further weaken the recovery of Canada's No. 1 customer, and a cautious stance looks pretty prudent.

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But unless those warning signs are making the bank rethink when the economy will be firing on all cylinders, the academics argue Mr. Carney still needs to bring monetary policy back to normal by the middle of next year.

"The question is, is the 'new normal' the same as the 'old normal?''' said Michael Gregory, a senior economist at BMO Nesbitt Burns, which changed its forecast for the resumption of rate hikes from July to September after Mr. Carney's speech.

For Mr. Gregory, the fact that Canada is not benefiting from the current commodity boom in the same way that it did earlier this decade - when the oil patch reaped the rewards of Chinese demand at the same time that the U.S. economy was far stronger than it is now and consumers there kept on buying Canadian goods - means neutral might be closer to 2 per cent.

"In that case, the Bank of Canada does have a lot of time,'' Mr. Gregory said.

Obviously, this type of nebulous, academic concept leaves much room for interpretation and confusion. Which is why Mr. Carney would do well to give a bit more sense of his latest thinking on what constitutes neutral in the current climate, where the global economy is healing but is clearly still under threat.

"What I would like is a statement from the Bank [of Canada] suitably written in code words, that says, 'we actually think there's not as much stimulus out there as previously thought,''' said Chris Ragan, a McGill University economist and the C.D. Howe Institute's David Dodge Chair in Monetary Policy. "That would suggest that whatever this concept of neutral is, it's lower than they used to think it is, and therefore they have more time to hang out at 1 per cent.''

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Mr. Gregory and Mr. Holt argue that the central bank's more guarded outlook actually has become more evident for those who choose to see it.

"Some of the more bullish forecasters are potentially making the same mistake they made in 2008, when they argued that high commodity prices could insulate Canada and we'll skate right on by," Mr. Holt said. "They forgot the fact that it creates massive demand destruction in our key export market."

In any case, Mr. Gregory points out, borrowing conditions are already tighter than they were a few months ago, even though rates have stood still. More and more households are tapped out, taking on less debt and spending more strategically in the face of higher gasoline costs, and tighter mortgage rules have helped cool the housing market. Combined with the strength of the loonie, those variables have put a brake on the economy, which is already slowing after a strong first quarter.

Still, Mr. Gregory says a little extra guidance is warranted, if for nothing else than to combat the notion that policy makers are giving mixed messages.

"It would be nice if we got some official pronouncement: 'Listen, we do believe we'll be back to full capacity by the middle of next year, and ordinarily rates would be back to their historic neutral levels, but things are anything but ordinary now,'" he said. "Even just saying that would help explain things a little bit."

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