Blurb: With the U.S. Federal Reserve having raised interest rates subsequent to its last two meetings, and with more hikes on the way, can the Bank of Canada be far behind?

Door wide open for Bank of Canada interest rate hikes

By Peter Diekmeyer o Bankrate.com

In recent weeks there have been increasing indications that the Bank of Canada will change course at its next meeting and start raising its key interest rates.

Bond markets had been anticipating a 50 basis point increase by the end of the year, but there remained some doubt as to how soon these hikes would come. Those doubts were largely erased by positive remarks about the domestic economy that David Longworth, the bank's deputy governor made to the Canadian Association of Business Economics last night (August 23rd).

According to Longworth, the Bank is now forecasting that Canadian Q2 GDP growth will be closer to 5 per cent than the 4 per cent predicted in its July Monetary Policy Update. Inflation is also running higher than expected, and the closely watched "output gap" --the difference between what an economy can potentially produce and what it is producing, -- is shrinking. Longworth also provided a broad hint as to how the bank will react to this news.

"Overall, with the output gap in Canada closing, we will need to reduce the amount of monetary stimulus in the economy to avoid a buildup of inflationary pressures," Longworth said. "But the timing and magnitude will depend on how prospects for inflation and capacity evolve."

An imminent rate hike?

These remarks are being interpreted by some as signaling that a rate hike is imminent. The speech is being given particular significance since it is the only speech by a Bank of Canada official on economic issues until the next central bank meeting, which is scheduled for September 8th.

"The door is now wide open for a rate hike," said Michel Doucet, vice-president (fixed-income strategy) at Desjardins Securities. "(Longworth's) comments really caught the markets off guard, because they weren't convinced a move would happen so soon."

According to Doucet, Canadian events are being largely influenced by events south-of-the-border.

U.S. picture remains foggy

U.S. Federal Reserve chairman Alan Greenspan recently announced that the Fed's monetary policy was shifting from accommodative to neutral. The statement's clarification of how high and how fast the Fed's key rate, -- which is currently 1.5 percent,-- will rise, remains an open question.

"What does 'neutral" mean?" said Doucet. "Does it mean 3 per cent or 4 percent? We really don't know."

As if the picture wasn't cloudy enough, more fog was supplied by a surprisingly week U.S. July employment report released earlier this month, which showed that only 32,000 jobs were created, compared to the 122,000 that the market expected. Another wild card will be the effect that the spike in oil prices will have on the thirsty U.S. economy, as well as its effect on inflation.

All of these factors call into question the timing as to how fast the Fed will bring its rates up. It has used the term "measured" to described the increases that it plans to make, but that term can mean a lot of things.

Canadian central bankers, --heavily depended on the need to balance their policy with the Americans', yet often just as eager to downplay that dependency-- tend to be just as murky.

One example has to do with inflation data, which Statistics Canada released today, showing that core inflation rose by a mere 1.9 percent in July, compared to 1.7 percent the previous month. Both numbers are well within the bank's 1 to 3 percent inflation target range.

Hence, although the inflation report released in itself only showed a slight increase, the fact that Longwroth referred to higher-than-expected inflation in his speech last night, carry a certain weight, because when central bank's are worried about inflation, rate hikes tend to be fast in coming.

Hike unlikely to affect house prices

But according to one expert, even if the Bank of Canada does raise rate rates by 25 basis points in September, it's unlikely to have a major effect on the Canadian housing market.

"An increase would affect administrative lending rates and short-term mortgage rates," said Gregory Klump, chief economist at the Canadian Real Estate Association. "But only about 20 percent of Canadians carry mortgages at a variable rate. The vast majority of mortgages are at fixed rates."

According to Klump, the most important Canadian mortgage rate to watch when assessing the effect on house prices is the five-year fixed rate, which is in itself more tied into the expectations of the bond market.

However the real question is what will happen if the Bank doesn't stop with its September hike, and it continues to make further moves down the line. After Longworth's remarks, Canadian bond markets immediately raised their expectation of rates increases to 75 basis points by year end. And what would happen to real estate prices under those conditions is anyone's guess.

 

Peter Diekmeyer is the Montreal Gazette's management columnist. He can be reached at: peter@peterdiekmeyer.com

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