Canada's Housing Bubble

Feb 18, 2010 Jeremy Torobin theglobeandmail.com

Central bank has promised to wait until at least July, but some economists argue conditions now call for earlier tightening

Bank of Canada Governor Mark Carney is grappling with a faster-than-expected increase in inflation that boosts the likelihood he will raise interest rates as soon as his “conditional” pledge to stay on hold through midyear runs out.
Mr. Carney's commitment to wait until July or later before raising interest rates from the current record-low level is based largely on his notion that inflation will stay below the central bank's 2-per-cent target until the second half of 2011. In January though, annual inflation quickened to 1.9 per cent, just shy of the key threshold. The core rate, which guides monetary policy because it strips out prices for volatile items such as fuel, jumped to 2 per cent from 1.5 per cent in December.

“As far as I'm concerned they've got the green light to hike now,” said Derek Holt, an economist at Scotia Capital Inc. in Toronto.

Policy makers will probably wait until summer to be sure the economy is ready, Mr. Holt said, but “one thing after another” is putting the bank in a position to move earlier should it choose to. Those factors, he said, include a “huge improvement” in funding and liquidity, a return to job growth late last year, estimates that the economy grew by as much as 4 per cent in the final three months of 2009, faster-than-expected core inflation, and “moribund” labour productivity that makes inflation more likely in the long term.

Still, the usual caveats about the strength of the economic recovery remain. Unemployment is retreating more slowly than economists and governments had hoped, particularly in the U.S., where the housing sector continues to sputter and many consumers remain cautious in their spending. Deficits in the U.S. and overseas are sky high, raising concerns about excessive debt loads for countries ranging from Greece to Japan.

In addition, steps taken by Finance Minister Jim Flaherty this week will make it tougher for some Canadians to qualify for mortgages, all but removing any pressure on Mr. Carney to further deter overstretched borrowers from taking on more debt than they'll be able to handle down the road.

And some economists argue the year-over-year increase in the core inflation rate last month was a function of just how bad things were in the gloomy days of January, 2009, when demand was plummeting worldwide, sending energy costs tumbling and prompting retailers to offer fire-sale discounts to trim bloated inventory left over from a disastrous holiday shopping season.

“Prices were falling a year ago, now they're increasing a little bit, so when you compare year to year, it looks like the inflation rate spiked up,” said Michael Gregory, an economist with BMO Nesbitt Burns in Toronto. Price gains in the current month, compared with February, 2009, will likely turn out to be more modest because costs increased last February from the previous month.

“The Bank of Canada's projection that inflation will average about 1.6 per cent in the first quarter, despite the fact we're starting off near 2 per cent, is still pretty much in the ballpark.”

Mr. Gregory said BMO has “pencilled in” July for Mr. Carney's first move, saying yesterday's inflation report may have made policy makers “a bit more antsy” about the need for higher rates at the earliest opportunity in the second half of the year.

Mr. Carney's July commitment has been the touchstone for predicting when rates will start to rise back to more normal levels. Up until now, post-recession slack in the economy has fed a perception the country is still months away from seeing genuine inflation pressures. In its latest forecast, released Jan. 21, the Bank of Canada surmised the economy wouldn't be running at full tilt until the second half of 2011 because the high loonie and still-subpar demand in the U.S. would crimp exports.

But a stronger-than-expected reading for growth in the fourth quarter would suggest that the slack in the economy is being absorbed more quickly than policy makers thought, and could point to a much speedier trajectory for inflation.

And that's why analysts who have insisted all along that Mr. Carney will tighten as soon as his conditional commitment runs out – or, in very rare cases, earlier – are more confident in their forecasts.

Yanick Desnoyers, assistant chief economist at National Bank Financial in Montreal, believes there's a possibility the central bank will pull the trigger in April, arguing that there's less slack in the economy than thought because of, for instance, auto industry plants that were shuttered during the downturn and which won't reopen.

“People are putting too much weight on the output gap argument, to assume there won't be any inflation problem,” Mr. Desnoyers said. Because interest rate moves can take a year or even longer to have an effect on the economy, “the clock is ticking,” he said.