Cutting interest rates in the midst of a financial meltdown may seem like a jog in the park for Mark Carney, the governor of the Bank of Canada, compared to the quandary he now faces. Signs of a recovery abound, most notably demonstrated by an “awe-inspiring” rebound in real estate. But the strengthening Canadian dollar has whacked the country’s trade sector, which accounts for more than a third of economic output. Bond-market traders anticipate signals from the central bank in its interest-rate statement on Tuesday that rates are headed upward soon, with yields on two-year bonds climbing nearly 50 basis points over the past two weeks. Analysts are of the opinion, however, that Mr. Carney will do his best next week to indicate he’s in no mood to pull the trigger on rate hikes because this economic recovery, regardless of how good some of the data look, has a soft underbelly. Mr. Carney has already committed to keep interest rates at the current record low of 0.25% until the end of the second quarter of 2010 in order to achieve the bank’s inflation target of 2%. “It is a pretty messy situation right now,” Eric Lascelles, chief economist and rates strategist at TD Securities, said of Mr. Carney’s conundrum. Mr. Lascelles has just returned from a two-week trip visiting TD clients in Europe, who he says are mostly convinced of a near-term Bank of Canada hike.
The conundrum for Mr. Carney is how to handle the two dichotomous forces shaping the economy without pushing the economy back into recession or allowing asset prices and inflation to get out of hand. First, domestic demand appears strong, as household credit growth remains positive, fuelling better-than-expected job growth and prompting businesses to adopt a more positive sales outlook for the coming year. The low interest-rate environment has also spurred what economists describe as an “awe-inspiring” rebound in housing, with data Thursday suggesting existing-home sales in September up almost 17% from year-ago levels, and a whopping 63% above the lows hit earlier in 2009. To avoid another financial crisis like the one just passed, there is a belief that central banks will pay more attention to appreciating asset prices, such as housing, when setting rates. Recall it was the U.S. subprime-mortgage mess that morphed into a global credit crisis and then a recession. In his much talked-about Jackson Hole, Wyo., speech in August, Mr. Carney said financial stability should be an objective of central-bank policy, alongside price stability.
Meanwhile, the Canadian dollar has experienced a surge of its own, climbing 26% from lows hit earlier this year and hitting a 14-month high this week. Mr. Carney has warned that persistent strength represents a risk to economic growth, and recent data might be making the case for him. The country recorded a record trade deficit in August of $2-billion, as the fall in exports outpaced the drop in imports. And Thursday, Statistics Canada indicated manufacturing shipments in August dropped by a larger-than-expected 2.1% on a month-over-month basis, due to weak aerospace and auto sales.
Sébastien Lavoie, economist at Laurentian Bank Securities, said the Canadian dollar, should it continue to trade above US95¢ for an extended period, could “sabotage” the growth outlook. In a note to clients, he said the dollar poses such a threat that he believes there is a greater probability the central bank intervenes in markets through so-called quantitative easing to push rates down further than there is of an earlier-than-expected rate hike. Perhaps the only way the Bank of Canada can determine how all these factors are influencing the economy is to look at inflation — for which updated data are available Friday. “It is the only constant barometer,” Michael Gregory, senior economist at BMO Capital Markets, said of the inflation target, whereby rates are set to achieve a 2% level. He added this is how the central bank handled the east-west economic divide earlier this decade, when higher commodity prices led to a boom in western provinces while central Canada’s manufacturing-heavy base struggled.
The consensus among Bay Street analysts is that headline inflation for September was flat, and core inflation — which the central bank watches closely — likely coming well below target at 1.3% on a year-over-year basis. The inflation is expected to stay below target for some time, Mr. Lavoie said, as the higher dollar filters through the economy and results in cheaper goods, while the amount of economic slack keeps a lid of companies’ pricing power and workers’ wages. “In our view, the Bank of Canada should begin to hike by the third quarter of next year, at the earliest, and not necessarily before the Fed does,” he said.