Thursday, April 26, 2012

Rate hike or not?

There are, once again, conflicting headlines with regard to the economy and the future of interest rates. On the one hand Canada’s recovery is picking up faster than expected,  which had the Bank of Canada’s (BOC) Mark Carney hinting at the eventual increase of interest rates – perhaps sooner than later. Both the central bank and the International Monetary Fund lifted their Canadian forecasts for the year, suggesting a slightly better global scenario is benefiting our labour market and boosting business confidence.

On Tuesday, April 17, Carney left his key rate untouched for a 13th consecutive decision – the 1 per cent overnight rate has been holding steady since September 2010. The balancing act for Carney is to ensure inflation stays under control as the economy strengthens, but without dampening consumer spending and/or curtailing business investment that will be crucial to the country’s growth over the next couple of years.

The BOC clearly laid out its case for raising rates. The bank boosted its 2012 growth forecast for Canada to 2.4%, from 2 % in January. While it cut its 2013 forecast to 2.4 per cent from 2.8 per cent, policy makers said the economy will be back at full tilt in the first half of 2013, instead of in the third quarter of that year.

Then a few days ago, Statistics Canada reported the inflation rate had dipped to 1.9% in March -- the first time since September 2010 that the rate has fallen below the Bank of Canada’s target of 2%.  So now what?

Over the past couple of years the mortgage industry has repeatedly warned Canadians to be careful with their finances because interest rates are bound to rise eventually. Yet the variable rate was deeply discounted until a few months ago and fixed rates have fallen to historic lows. And now, with Carney hinting that rates will rise, the mortgage industry is once again preparing clients.

When we take a look at the bigger picture there are some influences that suggest rates may not increase until much later than the summer of 2012 or Carney may even wait until 2013.

First of all, the U.S. Federal Reserve Board said it will stick with its near-zero rate until 2014, putting pressure on Canada to keep its prime rate as is. The rebound in the United States, Canada’s chief export market, seems to be coming in short bursts – forward momentum, then a retreat – suggesting that the U.S economy is still vulnerable and unsteady. Considering this is an election year, it’s likely to stay that way until the election is over. 

Secondly, the euro crisis, until a few days ago, was no longer considered an urgent threat, and then came the collapse of the Dutch government and once again Europe is in deep. 

Thirdly, at the mere hint of an interest rate hike, the loonie shot up more than a full cent against the U.S. dollar, which does not bode well for many of our business sectors.

Last week Carney did say the “timing and degree” of interest rate moves would depend on developments in the coming weeks. Those developments are already here. And while he has hinted at a summer hike, well, without a crystal ball, it’s still too early to call. Last July, Carney sent a strong signal that higher rates were coming, only to reverse that stance in September.  Avery Shenfeld, chief economist at CIBC World Markets said recently, “It won’t take much of a disappointment in growth for the Bank to further delay this next round of rate hikes.”

TD Economics believes that the BOC cannot raise interest rates by more than one percentage point while the Federal Reserve is on hold. Doing so would result in a dramatic rise in the loonie and could weaken the economy.

One thing we can be sure of is that when the hikes do come, they will be gradual.

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