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Will interest rates increase with inflation?

By Julian Beltrame, The Canadian Press
May 19, 2010 - 3:42:05 PM

Friday's inflation rate expected to open door to interest rate hikes: economists 

OTTAWA - Canadians likely have only two weeks left to enjoy historically low interest rates.

With global markets beginning to stabilize following the recent fears over a Greek debt default, economists say the pieces are falling into place for the Bank of Canada to move off its emergency 0.25 per cent rate on June 1.

Economists — and markets — have already pencilled in a doubling of the policy rate in two weeks. But that is only a beginning say analysts who believe governor Mark Carney will keep on hiking rates through the rest of the year.

Even the TD Bank, which only a few months ago was advising Carney to wait until at least the third quarter of 2010, is now calling for an incremental hike beginning in June.

The reason, says the bank's director of forecasting Beata Caranci, is that the Canadian economic recovery is well ahead of schedule with what looks like two consecutive quarters of five per cent and beyond growth, a jobs recovery more robust than predicted with another 109,000 added in April, and inflation — the key indicator for the central bank — heading toward two per cent.

"The bank is looking a year or year-and-a-half out, and they are looking at an output gap that is not going to be there anymore, so they've got to start adjusting now to get the interest rate at what would be considered more neutral," she explained.

"And if they don't go now, it could mean we see bigger adjustments down the road," she added.

Higher rates are meant to slow down excessive borrowing and head off asset bubbles like an overheated housing market, which the central bank has already highlighted as a risk. Cheap money is also seen as destabilizing in the long term, much as happened in the United States in the early part of the decade and eventually led to the most recent crisis.

Economists caution that the anticipated hikes by the central bank should not be seen as an attempt to slow down activity, but merely as moving to a more traditional posture. With inflation at near two per cent, the current 0.25 per cent level is actually a negative interest rate, they note.

The TD Bank and many others believe Canada's policy rate will hit 1.5 per cent by year's end, more in line with inflation.

Carney gave a strong hint last month that he was preparing to move, surprising observers by dropping his year-long conditional pledge not to hike rates until at least July.

He has since added an element of doubt into expectations by noting that he considered the very act of removing the conditional commitment to have been a policy tightening measure. The rate-hiking narrative took another detour earlier this month with the recent turmoil in equity and financial markets over government debt issues in southern Europe — that added new uncertainty to the global recovery scenario.

But unless Europe again flares up in a major way, the only question remaining for Carney will likely be answered Friday with the release of April inflation data by Statistics Canada, say economists.

The consensus is that headline inflation will rise to 1.6 per cent and core underlying inflation — the index the central bank closely watches — will edge up to 1.8 per cent.

Those numbers are still below the bank's two per cent target but economists say they are worried because inflation is digging in at a time when the economy is still operating far below capacity, and at a time when the Canadian dollar is near parity.

That is not the case in the U.S., where inflation is actually heading south and could once again approach zero by year's end.

"Even with the current volatility in financial markets, the Canadian story remains intact as underlying fundamentals continue to improve alongside strong corporate and household balance sheets," write Scotiabank economists Derek Holt and Karen Cordes Woods in forecasting an interest rate hike.

Bank of Montreal economist Douglas Porter says there is still a chance Carney will wait until July 20, or even later, especially if the European crisis threatens to leak into North American credit markets, or if there's a big downward surprise in underlying inflation Friday.

Increasing rates in Canada, especially since the U.S. is likely to keep its policy rate at zero until 2011, will put added upward pressure on the Canadian dollar, which will further depress the country's manufacturing and exporting sectors.

But Caranci believes the dollar impact will be minor, because markets have already priced in several moves by Carney ahead of the U.S. And the loonie's recent dip below parity to about 96 cents US has partly removed an important impediment to act on rates for the Bank of Canada, she adds.


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