INTEREST RATES: Bank of Canada puzzles observers

The global economic outlook is getting brighter, the Canadian job market looks to have stabilized, real estate continues to rise and equity markets remain elevated. Yet amid all this, the Bank of Canada exhibits reservations.

In its latest statement on interest-rate policy, the central bank yesterday mapped out some of the glaring potholes -- from a spunky Canadian dollar to dreadful levels of U. S consumer spending-- that are on the road to a self-sustained, private-sector-led Canadian recovery.

"Embedded in the statement is [a] note of caution that what has transpired since the world hit the floor last year has been built largely on fiscal and monetary stimulus, and there remains a huge question mark on what happens when the steroids are taken away," says Andrew Pyle, wealth advisor and markets commentator at ScotiaMcLeod.

Mark Carney, the bank governor, and his lieutenants tried to debunk expectations of an early rate-hike surprise by reiterating its intention to keep the benchmark rate at 0.25% until July, conditional on inflation hitting 2% in the third quarter of 2011. Remember, any hint of a rate increase is bound to attract traders keen for richer short-term returns, and as a result further push up the value of the Canadian dollar --one of two "significant" drags on growth the country faces, in the central bank's eyes.

To date, Canada has relied heavily on red-hot domestic demand -- witness the eye-popping strength in the housing -- for growth, as consumers capitalize on record-low borrowing costs. Even though final domestic demand grew 4.7% annualized in the third quarter of 2009, GDP expanded by a meagre 0.4% due to the drag in trade. At some point, analysts say, economic reality dictates that to "fully embark" on a recovery Canada will need to shift some of that growth from domestic households to external demand.

Meanwhile, another school of thought is that Mr. Carney wants to temper expectations ahead of more positive data that are bound to spark additional rate-hike speculation.

In particular, economists anticipate a "doozy" from U.S. fourth-quarter GDP, to be released on Jan. 29, with estimates ranging from growth of 5% to 10%. Yet, the Bank of Canada statement indicated the "low absolute level" of U.S. demand would continue to be a "significant" drag on Canadian economic activity.

"People, especially in financial markets, have a tendency to focus on rates of growth," said Carlos Leitao, chief economist at Laurentian Bank Securities. "That's fine, but don't forget to look at the level and [in the U.S.] it is so low that it is not going to put any pressure on capacity."

Stubbornly high U.S. unemployment, limited credit creation and a need to build up savings are expected to dampen growth in U.S. consumption for years to come, analysts warn.

The Bank of Canada reckons the global rebound "continues to depend on exceptional" monetary and fiscal stimulus. Once that stimulus evaporates, in 2011, the private sector should become the "sole driver" of domestic demand, the central bank said in one of the new sentences it added to the statement.

Michael Gregory, senior economist at BMO Capital Markets, says he takes that to mean government spending -- once fiscal stimulus is removed -- and net exports will be drags on the Canadian economy in the medium term. Governments in the industrialized world are already signalling the need to get a grip on their spending, or otherwise they face skyrocketing long-term borrowing costs.

"If the sole source of GDP growth is consumer and business spending, this points to a lower profile for interest rates than would otherwise be the case," he said, adding his previous call for Bank of Canada hikes beginning in July has "eroded slightly."

(prepared by Paul Vieira/Financial Post/National Post)