The Organization for Economic Co-operation and Development generally agrees with the Bank of Canada about the pace of Canada's economic recovery. But the two institutions disagree markedly on what Canada's central bank should do about it.
In its latest world economic outlook released Tuesday, the OECD projected that the excess capacity in the Canadian economy won't be absorbed until the end of 2015 – precisely the timing the Bank of Canada outlined in last month's monetary policy report. Both the OECD and the central bank see Canada's inflation rate by that time rising to 2 per cent, the long-standing target on which the bank's monetary policy is anchored.
But when it comes to the appropriate interest-rate policy for that outlook, the OECD proposes diverging wildly from the Bank of Canada's intended path. Close watchers of the Bank of Canada, reading the details of the bank's recent slashing of its economic outlook, generally agree that Canadian rate hikes won't begin until early 2015, and are unlikely to exceed 1.75 per cent (from the current 1 per cent) by the end of 2015. The OECD thinks that's not nearly enough – both in timing and scale.
"Monetary policy tightening may need to begin by late-2014 to avoid a buildup of inflationary pressures," the OECD report said. "It is assumed in the projection that the first policy rate increase occurs in the fourth quarter of 2014, and that the rate rises steadily to 2.25 per cent by the end of 2015."
Let's imagine, for argument's sake, that the OECD's prescribed policy path is more appropriate. If the Bank of Canada were to change its tune to something more like the one the OECD is whistling, what would be the implications?
Any hint of higher rates earlier would considerably shift market expectations. That would put upward pressure on interest rates in the Canadian bond market, generally raising borrowing costs. In terms of one of the central bank's priorities – to cool the overheated Canadian housing market – this would almost certainly help matters. On the other hand, a premature rise in borrowing rates would be a drag on an already sluggish economy and discourage business investment, another key priority.
An earlier-and-higher rate trajectory would also lend strength to the Canadian dollar. This may be critical to the Bank of Canada's caution; the bank's boss, Stephen Poloz, worked for years with Canada's export agency, and has identified a recovery in exports as a critical factor in the bank's economic growth outlook. A weaker dollar is a definite plus for exporters, and the currency's declines since the Bank of Canada lowered its rate outlook last month have not gone unnoticed. If Canadian rate expectations were to ratchet up again, especially before the U.S. Federal Reserve starts to tighten its own monetary policy with the anticipated tapering of its asset-purchasing programs, the Canadian dollar could see another flurry of buying that would set back an export recovery.
And all to stave off a perceived inflation threat that is little more than a distant fantasy at the moment. Canada's inflation rate is running at 1.1 per cent, in danger of slipping below the Bank of Canada's 1-to-3-per-cent target band.
Perhaps the Bank of Canada agrees with the OECD more than it is willing, just yet, to admit. But even if the central bank does, don't expect it to tweak its rates message until after the Fed begins tapering. Even if the OECD is right, the risks to this more aggressive stance outweigh the benefits.