Carney Makes His Move

Further to my recent post on the last Monetary Policy Report 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.

One comment

  • Isn’t this a very similar situation to what occurred in the States at the beginning of their meltdown, albeit a bit of a twist and potentially shaken not stirred?

    Raise rates, slow demand for housing, tighter credit bubble starts to slowly let air out of the economy and potentially bursts due to relaxed mortgage rules gets people in trouble, and that combined with declining demand for housing, bring prices down so that original mortgage value declines.

    Now if somehow, we have maintained a dimension of quality within the payroll of the country contra the US, then we can obviously hope that the bubble does not burst but rather is a slow deleveraging.

    However, I am not so sure we have that safety net of a quality payroll to rely on, i.e. what will the rate of consumer demand shrink from the deleveraging, and what will backstop to produce a slow decline rather than a loud burst- I am not convinced the economy is ready for life without a safety net yet. Not only that, but given the signal, will this lead to an international turn.

    (I highly doubt that we can influence the globe to that extent, but it could contribute in a qualitative way to change thinking out there and seeing rates increase at the global level is about as good as the move to austerity.)

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