May 9, 2012


Title: BOC in bind

Sub-title: Canada’s central bank must balance a wide range of contradictory data when deciding whether to raise its policy rate.


In recent weeks there were mounting signs that the Bank of Canada acted too fast last month by hinting it may raise interest rates earlier than had been expected. The central bank cited an improving economy and rising household debts as key reasons for its warning that “some modest withdrawal of the present considerable monetary policy stimulus may be appropriate.”


Yet shortly after the announcement was made, news emerged that Canadian GDP fell slightly in February. As if that were not enough, rising sovereign debt concerns in Europe and uncertainties regarding the sustainability of Chinese growth projections continued to raise doubts about the stability of financial markets and demand for Canadian exports.


However early this week extremely strong housing start data, particularly in the condo sector, clearly demonstrated what a difficult position the central bank is in. According to the Canada Mortgage Housing Corporation, the seasonally adjusted annual rate of housing starts rose to a dizzying five-year high of 244,900 units, far in excess of what traditional demand indicators would suggest are needed.


“The bubble mongering that has been going on seemed over played for some time,” noted Robert Kavcic, an economist with BMO Financial Group. “But that is no longer true. There is little question now that Canada’s residential construction sector is heated, with the big-city condo market boasting the highest temperature.”


Central bank constraints

The Bank of Canada is in a tough bind these days and needs to balance a wider variety of forces than usual when its sets its interest rate policy. That policy of keeping interest rates low, for an extended period of time, in order to help the economy escape the throws of the recent recession and financial crisis, has been relatively clear. Less clear though, has been how and when the central bank plans to get rates back up to more normal levels.


Generally the two main data points the central bank considers - inflation and unemployment – both indicate that interest rates ought to stay low. Canada’s unemployment rate, which at 7.4%, is low by international standards, is still relatively high, and the economy, while growing, is doing so sluggishly.


Worse, as Aron Gampel, of Scotia Economics notes, the global economic environment “remains sub-par,” which in turn affects demand for Canadian exports. That’s particularly true of the United States, Canada’s largest foreign market, which continues to grow at an uneven pace. This, coupled with the strong Canadian dollar, which is making our products less competitive down south, is making it hard for local businesses to maintain and build market share there.


Europe continues to struggle

But America isn’t alone. Europe too remains mired in sluggishness, with several countries in outright recession and things looking unlikely to get better anytime soon. Rising risk premiums on both Spanish and Italian debt, have been keeping interest rates there high, which in turn has forced the two governments to take painful austerity measures.


Businesses in both countries, whose interest rates are often linked in some way to government rates, are also feeling the pain. Add to that considerable unease in the lead-up to the recent French and Greek elections, as well as weaker global prices for many of the commodities that Canada produces, and you end up with a fairly unsavoury brew.


On the other hand, the Bank of Canada, particularly its governor Mark Carney, has also been nervously eyeing two factors, which would normally propel it towards caution. The first is Canada’s growing debt-to-income ratio, which some experts expect to rise from 151 per cent at the end of last year to 160 per cent – exactly where United States was just before its financial crisis. The second, is Canada’s red hot housing market, which, as Kavcik notes, may not cool as quickly as experts has been expecting. “The pickup in homebuilding has been far too persistent to be written off as just temporary,” he notes. “Starts have now topped the 200,000 level in seven of the past eight months.”


The big question facing housing sector stakeholders, whose fortunes remain in many ways tied to interest rate levels, is how the Bank of Canada will balance out all of these factors. Most economists continue to believe that no rate hikes are in the offing until at least 2013. Even then, any upwards movement is likely to be slow and gradual.


Whether that will be enough to keep supporting the strong housing sector data, in spite of the many downside economic risks, is anyone’s guess.



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