Carney warns U.S. default would have 'profound implications'

The governor of the Bank of Canada, Mark Carney, says a U.S. government default on its debt would have "profound implications" for financial markets and that "it's our view that's not something that should be tested."

Carney said Wednesday the bank does not expect the U.S. will default, but that there's no certainty about what the effects would be if it did.

He said if there is no agreement among U.S. lawmakers by the deadline, but no default because the government meets its interest and principal payments by deferring other spending, that would still likely slow the U.S. economy.

U.S. lawmakers continued Wednesday to debate various options for a deal to cut spending that would allow passage of a measure to increase the U.S. fiscal borrowing limit by the government's deadline of Aug. 2. The U.S. Treasury Department has said the country would be in default after that time.

Carney made the comments shortly after the bank released its latest outlook for the country's economic growth, saying that risks to the economy remain "roughly balanced" between a domestic economy that is picking up steam and a global economy that is facing more headwinds.

In its regular monetary policy report, the central bank added that it was closely watching the possibility that a worsening European debt crisis could drag down financial markets and spark a credit crisis around the world.

Q2 growth estimate cut

It reduced its estimate for how much the Canadian economy grew in the second three months of the year to 1.5 per cent, down from the two per cent estimate it gave in April.

However, the central bank said it expected the domestic economy will grow slightly faster in the second half of the year than thought earlier.

It predicted annual growth of 2.8 per cent for all of 2011, down slightly from an earlier estimate of 2.9 per cent.

"Although the global outlook remains broadly unchanged, global risks have intensified, most notably in Europe," it said.

The bank projected that the Canadian dollar will average $1.03 US this year, and the high loonie will be the chief competitive issue for Canadian businesses.

"However, an even stronger loonie is a price the bank seems willing to pay, given that a rising currency is seen as a key ingredient needed to help restrain core inflation in coming months," BMO Capital Markets chief economist Sherry Cooper said in a commentary.

The bank predicts that core inflation — which factors out such volatile items as food and energy prices — will rise above two per cent for a period early next year.

'There is zero indication that the bank is poised to aggressively move on rates.' —Sherry Cooper, chief economist, BMO Capital Markets

"The bank is preparing the groundwork for rate hikes later this year," Cooper said, "and may quietly welcome a further accompanying rise in the Canadian dollar to keep inflation in check."

"However, there is zero indication that the bank is poised to aggressively move on rates — Carney stressed the word 'some'  with regard to) the stimulus (of low rates) being withdrawn, in today's press conference — and the rate-hike case is built entirely on the assumption that the drama surrounding U.S. and European debt subsides."

The report attributed the slower-than-expected growth in the April-to-June quarter in part to the end of government stimulus spending, as well as higher food and energy prices that crimped consumer spending in Canada and the U.S.

The global economic fallout from the earthquake and tsunami in Japan that disrupted the supply of manufactured goods added to that, it said.

"The bank now estimates that these supply disruptions will subtract roughly three-quarters of a percentage point from GDP growth in Canada in the second quarter, a slightly larger impact than projected in the April report."

The outlook came a day after the bank kept its benchmark overnight rate target at one per cent.

However, the central bank hinted that as the Canadian economy continues to grow, it will look to raise it key interest rate, which directly affects prime lending rates at Canada's big banks and in turn variable-rate mortgages, lines of credit and other loans.