Canada's rate hikes tied to the Fed

When the Canadian dollar topped 95 cents (U.S.) last week, approaching a three-week high toward the end of a year that has seen the currency gain 16 per cent against the U.S. dollar, it deftly illustrated the biggest influence on what will be Mark Carney's most crucial decision of 2010.

As economists and investors debate with increasing vigour about when the Bank of Canada will raise interest rates from their current rock-bottom level, the effect such a move could have on the loonie may mean borrowing costs have to stay where they are well into the recovery.

The central bank chief pledged last April to keep his main interest rate at the record-low level of 0.25 per cent until at least June, 2010, in order to stimulate enough borrowing and spending to solidify the economy's recovery. The resulting ultra-cheap mortgages spurred a buying spree in housing, and by the fall, Mr. Carney was stick-handling around endless talk – from just about anywhere other than the central bank – of a potential asset bubble in residential real estate.

While saying the white-hot market was a result of pent-up demand from Canadians who had put off purchases during the worst days of the recession, Mr. Carney finished the year warning people to avoid taking on more debt than they would be able to handle when interest rates rise again.

But even as the central bank characterized its concerns about Canadians' debt loads as a low risk to spread through the financial system, Mr. Carney emphasized that his commitment to wait until June before tightening monetary policy was very much conditional on the outlook for the bank's 2-per-cent inflation target.

"I'm not worried that we're in a box, because if things change we would change policy as appropriate," Mr. Carney told BNN in a year-end television interview that aired Dec. 17. "We have the flexibility to adjust it, either by shortening or lengthening [the waiting period], if that's what's necessary to achieve our mandate.''

And that's where the loonie comes in. To keep the housing sector in check, Mr. Carney can do little more than manage expectations for a rate hike that will come eventually, at a time of his choosing. That's in part because inflation is still below the bank's target.

It's also because with borrowing costs so low in most of the world's major economies, raising interest rates would make Canada a more attractive place for international investors seeking higher yields, which could send the dollar soaring. That would further complicate life for exporters trying to regain a footing in global markets.

"Given the remarkable homogeneity of monetary policy around the world, you really do risk being that tall poppy and getting hit quite hard by the currency," said Eric Lascelles, a strategist at TD Securities in Toronto.Last Thursday, the dollar rose 0.8 per cent in part because investors had become more convinced the central bank was considering a rate hike before mid-2010 or, at the very least, before the U.S. Federal Reserve, which many investors see keeping rates near zero into 2011.

The central bank, which will update its forecasts the week of Jan. 18, currently maintains it could take until the third quarter of 2011 for inflation to return to 2 per cent and for the economy to be running at full tilt, largely because of the currency's drag on sales of Canadian goods abroad.

Some analysts are painting Mr. Carney's assessment as too cautious.

"Both growth and inflation risks lie north of the Bank of Canada's current forecasts," Yilin Nie and David Cho, strategists at Morgan Stanley, wrote in a recent research report. "We believe the bank will need to hike before its conditional commitment to keep rates low until June, 2010, and before the Fed. Our forecasts show the first Bank of Canada rate hike in April, 2010."

Most Canadian economists, meanwhile, remain in wait-and-see mode. Michael Gregory of BMO Nesbitt Burns recently wrote in a note to investors that he sees "increasing risk that the policy rate renormalization process will kick off soon after Canada Day, with a small but not small-enough-to-ignore possibility that the first action could occur even earlier."

At the opposite extreme, however, are those who believe Mr. Carney will wait until late next year, or even later, to tighten – not least because the effect on the currency could be too severe should the central bank's rate be lower than the Fed's for more than a few months.

"The Bank of Canada will think very, very hard before raising interest rates ahead of the Fed," said Benjamin Tal, a senior economist at CIBC World Markets. He predicts a slow U.S. recovery will keep the Fed on hold and force Mr. Carney to wait until the first quarter of 2011. "To an extent, not fully but to an extent, monetary policy in Canada is being highly influenced by developments in Washington."

Mr. Lascelles of TD Securities said the Fed won't abandon its unprecedented stimulus until early 2011, with the Bank of Canada therefore waiting until the fourth quarter of 2010, even though Canada's economy is poised to heal more quickly than that of the United States. The bank "can and probably should hike rates before the Fed because of stronger fundamentals, but it really is quite restricted in terms of how much sooner it can go."

(prepared by Jeremy Torobin/Globe & Mail)