Carney Makes His Move

Further to my recent post on the last Monetary Policy Report  http://www.progressive-economics.ca/2010/05/11/the-bank-of-canada-and-the-recovery/ I cannot claim to be surprised that the the Bank of Canada has decided to begin to raise interest rates, albeit by an initial quarter point from  extraordinarily low levels. They are also returning to normal overnight money market operations which will tighten credit to a degree.

I still fail to see a very compelling case for monetary tightening when inflation is still very subdued, and when the “real” unemployment rate – a good indicator of labour market slack – is still very high  (11.8% in April 2010 compared to a pre recession level 8.9% in April, 2008.)
That said, one can concede that the Bank is in a bit of a box. Ultra low interest rates may not be sparking consumer price inflation, but they have been stoking a clearly unsustainable growth of household debt.

The preliminary OECD Economic Outlook (full text not yet on line) has this to say:

“Contrary to most other OECD countries, Canadian households have continued to borrow throughout the recession, much of it in the form of mortgages. The ratio of household debt to disposable income has thus reached a record high, as have real house prices. Deleveraging is needed..”

The view that we are in a dangerous housing bubble and that households have become dangerously over-extended is likely shared by the Bank and the Government of Canada, or the OECD would not have been so blunt.

The problem with hiking interest rates, of course, is that the impact will go well beyond slowing the rate of growth of household credit. It will make it marginally more expensive for businesses to finance new real investments, and it will help validate a dangerously over-valued Canadian dollar. The high dollar is very likely to slow a pick-up in the resource sector, and to derail any nascent recovery in the manufacturing sector.

The Bank say in today’s statement that ” (t)he anticipated pickup in business investment will be important for a more balanced recovery.” The OECD forecast for Canada looks forward to 7.5% increase in business non residential investment from the fourth quarter of this year to the fourth quarter of 2011, and 6.8% export growth over the same period.

Those numbers sound pretty optimistic to me, and they are needed to maintain in the recovery in the face of the pending withdrawal of fiscal stimulus, and the deliberate tightening of household credit.
Economic orthodoxy has put the Bank in a bit of a box. They feel the need to restrain household credit growth and favour fiscal tightening, but are no doubt less than supremely confident that business investment and exports can pick up the slack.

The alternative would be to maintain ultra low interest rates until the slack in the job market is taken up, but to slow the excessive growth of household credit through more direct means.