Canada’s business press has recently been filled with speculation that the Bank of Canada may soon hike interest rates based on its somewhat more optimistic economic outlook. But today’s Consumer Price Index report indicates that there is no need to raise interest rates. Statistics Canada reported that both headline and core inflation fell to 1.9% in March, slightly below the central bank’s 2% target.
Higher interest rates are not warranted to combat already low inflation, but could derail Canada’s fragile economic recovery by increasing borrowing costs and driving up the overvalued loonie. The latest OECD data on purchasing power parity indicates that the loonie should be worth 76 American cents.
The fact that financial markets price Canadian exports at a far higher exchange rate is producing a huge trade deficit. Higher interest rates would aggravate this imbalance, which the Bank of Canada has identified as a drag on economic growth.
Accommodative monetary policy will also be needed to cushion the effect of tightening fiscal policy. With both federal and provincial governments cutting back, Canada’s economy is not well positioned to also absorb higher borrowing costs and an even higher exchange rate.
The only seemingly legitimate rationale for higher interest rates would be to curtail household debt. However, consumer borrowing can be addressed through financial regulation rather than monetary policy.
A positive feature of today’s Consumer Price Index figures is that Canada’s average hourly wage has finally increased more than inflation (2.6% versus 1.9% in March). But Ontario wages continue to lag behind provincial inflation (1.8% versus 2.2%).
UPDATE (April 20): Interviewed on CityNews and BNN (video)
UPDATE (April 21): Quoted in today’s Financial Post and other Postmedia newspapers
- Inflation Collapse Confounds Monetary Hawks (May 17th, 2013)
- Polozogistics: Nine Thoughts About the Choice of the New Bank of Canada Governor (May 3rd, 2013)
- Margaret Thatcher’s Economic Legacy (April 16th, 2013)
- Mark Carney’s tenure and the state of monetary policy (November 27th, 2012)
- Prices Decline Yet Again (August 17th, 2012)