Split thinking on possible bank rate hike

A hike in Canada’s bank rate in July, once considered a slam-dunk among the country’s economic intelligentsia, appears no longer to be a sure thing when the Bank of Canada meets this week.

Flagging international economic growth and the central bank governor's worries about Canada’s recovery have squeezed out inflationary concerns as the dominant storyline among economists.

Although most practitioners of the dismal science still believe Canada will face higher borrowing costs, many see rate hikes in the fall, not the summer. The Bank of Canada will make an announcement Tuesday at 9 a.m. ET.

"We think the BoC will need a minimum of a couple of quarters of solid economic growth in order to evaluate what kind of traction the economic recovery may have before it pulls the trigger lest it risk hiking and reversing course soon thereafter," wrote Scotiabank economists Derek Holt and Karen Cordes Woods in a July 8 commentary.

Change tack

Signals of a reduced likelihood for a July interest rate hike by the Bank of Canada came in late June.

In an interview with the Wall Street Journal, Bank of Canada governor Mark Carney spoke of the strong "headwinds" faced by Canada’s economy in the coming months.

Instead of a central banker’s usual obsession with inflation, Carney talked about GDP growth concerns.

BMO senior economists Michael Gregory and Benjamin Reitzes believe the bank will do nothing on July 19.

BMO predicts the central bank’s overnight rate will stay at the current one per cent level until the fall and wind up at 1.35 per cent by the end of the year.

Growing pains

Like many economists, Gregory and Reitzes find themselves trying to make interest rate predictions based upon contradictory evidence.

Canada's trading partners are only slowly recovering, even as the rising value of the loonie makes Canadian goods less competitive in the global marketplace.

So far, Canada’s exports have not recovered to pre-recession levels.

In May 2011, Canada sold almost $37 billion in merchandise to foreign countries, a gain of 7.8 per cent compared with May 2010.

Prior to the recession in May 2008, national exports hit $42 billion. And the difference in sales is even greater when higher prices are taken into account.

Exports in all of 2010 were 17 per cent below 2008 levels, again before adjusting for inflation.

Canada’s tepid export recovery is not merely a reflection of flagging demand by foreigners.

In mid-July, the Canadian currency was trading at $1.05 US, more than a dime higher than in July 2008, when the loonie was worth 93 cents US.

A high domestic dollar means that Canadian goods become more expensive when translated into foreign currencies.

Financial problems

As well, Europe and the United States face serious challenges to their economic recoveries.

Across the Atlantic, countries from Hungary to the United Kingdom could face a severe financial squeeze if a debt-laden country, such as Greece and Portugal, defaults.

That type of a financial failure could lead to wider repercussions, as banking sectors in most European countries are exposed to these ailing countries.

"The risk of contagion to Italy and Spain marks a very dangerous and worrying turn in the eurozone saga," said David Tulk, chief Canada macro strategies for TD Bank Economics.

The U.S. economy does not appear to be faring any better.

Although not overly exposed to European debt, the United States faces a government stalemate over whether to increase Washington’s ability to borrow more money.

Failure by the Obama administration and the Republican-led Congress to get a debt deal would risk forcing the world’s biggest economy to default.

Even if Washington can escape this financial sword of Damocles, the U.S. economy still has too many individuals carrying too much debt and companies only cautiously investing in new machinery and employees.

Those factors have combined to dampen a U.S. retail recovery — with 2010 sales still 13 per cent below 2008 levels — and an American jobless rate still above nine per cent in mid-2011.

Inflationary dragon

Still, central bankers worry about inflation. And Carney is unlikely to ignore the recent acceleration in Canada’s consumer price index (CPI).

In May, Canadian prices rose 3.7 per cent compared with the same month a year earlier. That gain represented the third month in a row in which the CPI was greater than three per cent, a crucial level for the Bank of Canada.

Canada’s central bank has a target range for inflation at between one per cent and three per cent. Anywhere inside the ropes keeps Carney’s finger off the interest rate trigger.

At levels greater than three per cent for a prolonged period, however, the inflation hawks get chattering.

"The need for the bank to communicate better its determination to bring inflation back to target, even at the cost of surprising the market, was a stronger consideration [in favour of a rate hike], "said the C.D. Howe Institute, a Toronto-based economic think-tank.

The C.D. Howe Institute said the central bank should raise interest rates this time around to reduce worries among financial markets that Canada will to tolerate inflation at levels higher than the upward bounds of its own target.