Higher interest rates, but why?

Despite our protests on this blog, and Erin Weir chaining himself to the central staircase of the Bank of Canada, our hawks at the Bank raised interest rates today. That is, it raised the overnight rate by a quarter point to 4.5%. The Bank’s press release is a bit unusual in that there is no obvious reason why this move is being made:

The Canadian economy is now projected to grow by 2.5 per cent in 2007, somewhat stronger than was expected in April, and to grow somewhat more slowly in 2008 and 2009 than previously projected. In this new projection, higher interest rates across the yield curve and a higher assumed range for the Canadian dollar of 93 to 95.5 cents U.S. act to moderate growth in 2008 and 2009 to an average of about 2 1/2 per cent. This brings aggregate demand and supply in Canada back into balance in 2009.

Inflation is projected to be slightly higher and more persistent than in the April MPR. However, as excess demand diminishes, total CPI and core inflation should decline to 2 per cent by early 2009.

Canadian growth is not projected to be stellar this year (and if Saudi Alberta is taken out of the equation the growth rate is even lower), slowing in 2008 and 2009. The dollar is way up, compounding the negative hit in central Canada. And given that inflation, at 2.2% in May, is in fact quite low, it is hard to see what the fuss is all about. In fact, US inflation in May was about half a percentage point higher, at 2.7%.

The Globe’s coverage quotes another industry analyst, without reference to his potential conflict of interest, to let us know that more hikes are on the way, and the bank itself to suggest that even that is not the end of this road:

“We are expecting another 25-basis-point rate hike on Sept. 5 to 4.75 per cent, followed by a brief pause to gauge the effect of both the higher interest rates and the recent appreciation of the Canadian dollar,” said Ted Carmichael, chief economist of J.P. Morgan Securities Canada Inc., in a note.

… “Some modest further increase in the overnight rate may be required to bring inflation back to the target over the medium term,” the bank said in a statement. The sentence marks a shift in the bank’s stance: in its previous statement in May, it said increases would be needed in the “short term” and it didn’t use the word “modest” — the new statement thereby suggesting that interest rates aren’t poised to soar.

The Globe story, apparently some editorializing by the author, says the Bank is concerned that “price increases could spiral if it doesn’t act”. Spiral? Concern about higher inflation is one thing, but what data suggest that the very modest rise in inflation over the past year will somehow lead us into an inflationary spiral?

The Globe does report that “Tuesday’s move is bound to prove unpopular with exporters, which have watched this year’s 10.7-per-cent surge in the Canadian dollar with growing alarm.” On the other hand, it all depends on who you are. I went to the US last week, and I must say that the high dollar was pretty sweet, as you can almost think of the dollars being at parity. But this, I imagine, is cold comfort for manufacturers and exporters in central Canada.

PS. Erin Weir did not actually chain himself to the Bank of Canada.

3 comments

  • Maybe somebody could explain this to me as I seemed to be chasing my tail. If oil sets about increasing at the rate it has over the past 3 years, do we not expect that inflationary pressure from such short run increases to eventually take hold in the medium and long term. Yes I understand that it is a bit of a debate but is not this “spiraling inflation”, albeit take away some proportion of regional over heating, add in some shell shocked central portions, and mix in a bit of stagnating wages, and a few other bits, do we not seem to be headed for some kind of longer run stag-flationary scenarios ( I would qualify this a bit as instead of unemployment we see a dramatic increase in lower quality employment, whether the distribution of this unfolding labour market is sustainable is another matter).

    The only bank speak I hear is over heated economy. Anybody have any readings or such that they may want to suggest.

    Although I must admit there does not seem to be any inflationary data showing up.

  • Well, the big joke is that when fuel prices started to rise, they started to resort to using the “core” inflation rate that excluded the impact of fuel. I’m glad they did it, but it’s a bit disingenuous. That means that for a few years now, the central bank has been turning a blind eye to some inflation, for fear that they would have to jack up interest rates when the economy isn’t doing all that well outside of Alberta. At some point we stop pretending that oil prices are not a part of our core economy. The oil sector may be a bit “hewers of wood, drawers of water” but with developing countries emerging from poverty, we could potentially see the price of natural resources increasing for a prolonged period. Then spin-off industries that used to feast off of Ontairo’s manufacturing dollars will start building up around oil-rich regions and firms. So the cost of living in those regions would become more important, and we would have to drop the core inflation facade.

    I also have a question. Does anyone know about the impact of expectancy theory, in the way forecasts by bankers of rate increases could become self-fulfilling prophesies by forcing the financial markets to all but cause the governor to hike rates? I’m rusty in this area, so I’m curious if someone out there has some insights.

  • Why raise rates? Think 71-74. This time they are going to contain prices (read wages not assets) via unemployment induced by a high dollar. In their eyes, I am sure they look back on 71-74 and are convinced that is when the foundations for the price spiral were created. The quantity theory of money may be dead (as a practicable strategy for dealing with inflation) but the fear of the mob is not.

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