June 2011


Title: Where to with interest rates?

Sub-title: With Canada’s economy going great guns, a central bank interest rate hike may be in the cards. However there are risks on the horizon.


The Canadian economy has been doing surprisingly well lately. Job creation has been strong, the unemployment rate slipped to 7.4 percent last month and economic growth during the first quarter came in at an annualized 3.9 percent gain.


Our position is especially bright when one considers the tough economic times that have beset the world since the 2008 financial crisis and subsequent recession. On the other hand, Canadians have been taking advantage of the good times, borrowing and spending a little too much.


When that happens, the Bank of Canada, tends to want to tighten the money supply so that core inflation, which so far has remained moderate, stays that way. “Canada’s employment situation is very favourable,” notes Benoit Durocher, a senior economist at Desjardins Group. “(It) continues to show that a key interest rate increase will be needed in the coming months.”


Risks are piling up

Yet despite the good news so far, the Canadian economy is sailing on a global sea of turmoil says one expert. “There is enormous uncertainty about how economic and financial events will unfold,” says Craig Alexander, a senior vice-president and chief economist at TD Economics, who cites three areas of concern.


The first relates to continued worries about whether Greece will eventually default on the enormous debts that it has racked up. Last year, key European Union countries and the International Monetary Fund put together a bailout package that was contingent on Greece tightening its purse strings.


However financial markets are unconvinced that the plan was tough enough or that the Greek government will implement it correctly. As a result lenders are now demanding punitively high interest rates to take on Greek debt. The question many are now asking is not if, but when, the country will default and what impact that would have on the world financial system.


The second major risk to the global economy relates to uncertainty in the Middle East, more particularly NATO’s latest war in Libya. Canada, the United States, France and England are currently conducting a punitive bombing campaign in this major oil producer. The problem is that no one is quite sure what effect supply disruptions could have on world energy prices nor whether the “Arab spring” revolts will spread. Right now it looks like the United States has quietly given its oil producing allies such as Saudi Arabia and Bahrain the green light to use force against demonstrators, so there are unlikely to be any major long-term oil supply disruptions. However markets continue to have great short-term worries.


Our biggest customer

The final and possibly most important risk to the Canadian economy stems from sluggishness in the United States, our largest trading partner. The US government is mired in gridlock in its efforts to tackle a ballooning national debt and the country’s housing sector continues to languish. Many experts believe that despite the massive residential real estate price declines that have already occurred, that downward momentum remains.


The upshot will likely continued weak US domestic demand for some time. If that happens, it would have a terrible effect on Canadian exporters, who are already hampered by a strong loonie (which makes their products more expensive in US markets) and are thus fighting desperately to maintain their share there.


The shear magnitude of the risks floating around has caused Alexander to revise his monetary policy outlook. “TD Economics no longer expects the Bank of Canada to raise the overnight rate this year,” he wrote in a letter to clients this week. “Instead, tightening in monetary policy is anticipated to begin in early 2012, with the overnight rate climbing to 2.00 percent by the middle of (next) year.”


That said, even if Alexander is wrong and interest rates rise at a faster pace, according to the vast majority of forecasts out there, they will continue to remain exceptionally low by historical standards.


That means Canadian consumers will have an added incentive to continue their shopping, and that the country’s housing market, which has been doing just fine thank you, will benefit from an excellent source of forward stimulus.



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