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Deflating the Monetary Hawks

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

Enjoy and share:

Comments

Comment from Jeff
Time: April 20, 2012, 9:24 am

Bang on.

I think Carney would agree with your assessment in private, but his job is to scare people about interest rates to deter further accumulation of household debt. Hence he hints at higher rates when privately I suspect he is preparing to cut them further as fiscal policy tightens.

Comment from Ken Howe
Time: April 20, 2012, 9:52 am

Gosh I’m surely going to be rushing out to pay off my household debt the minute interest rates go up. Perhaps I’ll just exercise a few stock options or liquidate a few preferred shares. Like most Canadians I chose to accumulate household debt because of the high returns available thanks to low interest rates and of course am under no financial stress whatsoever.

Comment from Darwin O’Connor
Time: April 20, 2012, 10:59 am

While Ken may be joking, much of the house bubble in Canada is driven by wealthy speculators buying up condos and they do think like that. They would be influenced by the threat of high interest rates.

Comment from MikeB
Time: April 20, 2012, 11:12 am

I’m recently back from a few years in the US, where I saw first hand the effects of a housing slowdown. It is not pretty. I know our speculator ratio here is lower, but it still exists. Interestingly, with zero down or other limited mortgages, it doesn’t take a price drop to get in trouble, an end to price growth will do it. There are going to be a lot of people out of work due to the recent budgets. EI doesn’t make a mortgage payment in many places under the conditions we have. A small decline in the price and suddenly selling to take a job on another town is not possible and the ugly spiral begins.

Questions:
1. How can the CPI be so low given our increases in energy and housing lately?
2. Is CPI inflation?

I thought increases in the price level were only part of inflation and that wage gains were the other part. Is it possible that the price level will increase (due to energy and environmental shocks), yet the wage level doesn’t follow. It seems our standard of living can only go so low and we already have some making a choice between food and lodging.

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