Tuesday, October 16, 2007

Bank of Canada is expected to "stand pat" on rates

Just a few weeks ago, most economists were expecting the Bank of Canada would again boost its key lending rate at the Sept. 5 policy meeting, following a similar hike in July. Not any more.

Now, the central bank is widely expected to stay on the sidelines when it announces its rate decision at 9 a.m. ET Wednesday. Recent surveys of economists by Bloomberg and Reuters failed to find any who believed the bank would hike rates.

Bank of Canada Governor David Dodge, left, and senior deputy governor Paul Jenkins leave their office for a news conference in mid- July.
(Tom Hanson/Canadian Press) What could cause such an abrupt change of heart, since the Bank of Canada indicated less than two months ago that "modest" rate hikes might be needed to wrestle inflation down?

"The answer is the financial market volatility over the last few weeks, caused by concern about exposure to U.S. subprime mortgages," said TD Securities economist Jacquie Douglas in a commentary issued last Thursday.

Douglas said the central bank's deputy governor, Pierre Duguay, hinted at just such a pause in a speech last week, when he noted that "given recent events in global credit markets, we need to assess the extent to which the risks around our July projection have shifted."

Stock markets in Canada have endured some heart-stopping declines since mid-July's record highs as investors worried about whether exposure to the risky U.S. subprime mortgage market would lead to wider economic fallout and a general tightening of credit and liquidity in Canada.

Given that the Bank of Canada was busy injecting billions of dollars into the fragile financial markets in early August to boost liquidity and keep its key overnight lending rate at 4.50 per cent, observers say it would send a decidedly mixed message to turn around and hike rates just a month later.

"An increase … in the very overnight rate the bank has been working so hard to keep down would badly compromise the clarity of that statement [of support for Canadian financial markets]," C.D. Howe Institute fellow-in-residence David Laidler said in a recent op-ed piece.

Inflationary pressures persist
But it's worth noting that, minus the current volatility in financial markets, the Bank of Canada would likely be raising interest rates.

For one thing, inflationary pressures persist. Core inflation was running at 2.3 per cent in the latest cost of living report — above the central bank's target of 2.0 per cent.

Wages have also been growing faster than inflation, the country's unemployment rate is at a record low, and figures out last week showed that GDP in the second quarter grew at a stronger-than-expected annual rate of 3.4 per cent.

These are not signs of a dramatically cooling economy.

TD Securities, for one, thinks the Bank of Canada will return to rate-hiking mode as early as October, after concluding the U.S. subprime market does not pose "all that big of a risk" to the Canadian economy.

Others don't see the central bank hiking until the new year. "In this environment, it still appears that the next move by the Bank of Canada will be to eventually start hiking rates again, although the depth and duration of the credit squeeze will determine when they get back to the tightening wheel," said BMO Capital Markets economist Doug Porter. "We believe that won't be until early in 2008."

A few economists are even calling for a rate cut by December.

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