INTEREST RATES: Interest rates might be forced to rise

The Reserve Bank of Australia has become the first major central bank to raise interest rates since the financial crisis, highlighting rising home and stock prices --factors other central bankers are expected to make more prominent as they seek to prevent a repeat of debilitating asset bubbles.

The surprise move by Glenn Stevens, Australia's central banker, was greeted with market enthusiasm, and was interpreted as a sign a global recovery was on track. Equities, commodity prices and the Canadian dollar surged on the move, although giving up some gains in later trading.

The Australian rate increase, which also factored in growth and inflation, puts the spotlight on other central banks, such as Canada's, which has been steadfast in setting rates to ensure a 2% inflation target.

But inflation in Canada is seen to remain benign until 2011, forecasters say, due to excess manufacturing capacity and a strong Canadian dollar that will keep a lid on import prices.

The loonie reached a one-year high yesterday of US94.82¢, before closing at US94.38¢, up US0.93¢ from Monday's close.

"Inflation is not going to be a problem. Consumer spending, and the consumer response to cheap money, however, may be a problem," said Stewart Hall, economist with HSBC Securities Canada.

Consumer response is what might push the Bank of Canada, as it did its Australian counterpart. The Australian bank cited solid gains in housing prices and a "significant" recovery in equity markets for raising its benchmark rate 25 basis points to 3.25%.

"I do get the sense asset prices are going to play a greater role in the formation of monetary policy," said Michael Gregory, senior economist at BMO Capital Markets. "Because the amount of stimulus is unprecedented, and at emergency levels, removing it won't follow the same rules of thumb."

As a result, he said, central bankers might be looking at new measures to determine when to raise rates. As opposed to looking strictly at inflation and growth, Mr. Gregory said central banks might be forced to pay as much attention to asset prices and credit spreads.

In Australia, the central bank has always paid close attention to housing prices -- which are a national obsession and have been on a tear over the past decade -- and view them as a guage of the overall strength of the economy.

One of the main debates in the aftermath of the financial crisis is the role central banks should play in averting future meltdowns, and what powers they should be granted to execute this task. By taking on a beefed-up role as overseeing the financial system, central banks would be expected to identify asset bubbles and pop them before they burst. The collapse of the U.S. real estate market, fuelled by low lending rates that attracted less-creditworthy buyers, sparked a credit crisis and global recession.

"The general view before the calamity was that monetary policy was not an effective tool in dealing with asset bubbles," said Craig Alexander, deputy chief economist at Toronto-Dominion Bank. "But given how much damage was caused by the U.S. housing bubble, the view now is that cleaning up the mess afterward can be far too costly and that monetary policy may need to be responsive to asset prices."

As it happens, Mr. Alexander was a co-author of a TD report released yesterday, suggesting the Bank of Canada might be forced to raise rates before it anticipated should Canada's housing market continue its stellar performance.

Mr. Hall said the Bank of Canada has put itself in a "tiny bit" of a box by indicating it was prepared to keep its key interest rate at 0.25% until June 2010, on the condition that inflation would hit the 2% target in early 2011.

But Mr. Hall said the central bank "would do what it wants to do" should circumstances arise. "It won't get trapped by anything."

The Bank of Canada is set to deliver its next interest rate announcement on Oct. 20, followed by an updated economic outlook two days later. Analysts will be eyeing the documents closely for any change in tone regarding rates. In the meantime, the Bank of Canada's senior deputy governor, Paul Jenkins, is scheduled to speak in Vancouver tomorrow regarding the future "challenges" facing central banking.

("Defying Gravity" prepared by Paul Viera/National Post)