INTEREST RATES: Sharp hike in interest rates urged later this year

The Bank of Canada should hold to its pledge to keep its key policy rate at 0.25 per cent until July, but should then embark on sharp rate hikes until mid-2011, according to an analysis prepared for the C.D. Howe Institute.

The call for increases emerged Tuesday, one week before the Bank of Canada releases its latest interest-rate statement. The report calls for increases of 50 basis points-- or one half of one per cent -- at every announcement of the central bank's key interest rates after July.

Recent data indicate the Canadian economy likely expanded in the final quarter of 2009 at a faster pace than the central bank expected (four per cent versus 3.3 per cent), and inflation is now closer to the central bank's two per cent preferred target than it previously envisaged.

The report suggested the central bank, in response to the recession, cut rates at a pace faster than the drop in inflation. As a result, the central bank should follow a similar pattern in increasing borrowing costs at a rate faster than inflation once the recovery takes hold, argued Michael Parkin, an economics professor at the University of Western Ontario.

Based on a number of assumptions, Parkin calculates that increases of 50 basis points from now until mid-2011 are appropriate, leading to a central bank benchmark rate of roughly 4.25 per cent (assuming eight scheduled announcements from July to the middle of next year).

"While the bank might want to raise the overnight rate more slowly than 50 basis points at every announcement date, doing so would keep the real overnight rate negative through a period in which the economy is returning to normal and run a serious risk of leading to excess demand and rising inflation expectations in 2012 and 2013," Parkin wrote.

Still, the bank should keep its conditional commitment to leave the benchmark rate unchanged until July or risk damaging its credibility, Parkin said. Other conclusions from his analysis include:

- The bank should publish conditional statements about the future path of the policy rate to help shape market expectations and avoid surprises that disrupt financial markets, output, and employment.

- Measures aimed at easing credit conditions should be unwound but "with care," he added, to ensure a gradual return to normalcy in credit markets.

(Source: Vancouver Sun)