Household imbalances keeping Bank of Canada from setting lower rates, analyst says

Gordon Isfeld Financial Post
30/10/13 4:39 PM ET

OTTAWA — It might have been a closer call than we thought.

After 18 months of telling consumers and markets that its key interest rate would eventually be lifted from 1%, close to rock bottom, the Bank of Canada shifted gears into neutral.

But it could just as easily have swung in the opposite direction, perhaps dropping 25 basis points, if the economic climate in Canada was more predictable.

“If it were not for the concerns about household imbalances, the BoC would have cut its policy rate at last week’s [policy] meeting,” says Nomura Securities economist Charles St-Arnaud.

Add to those concerns the fact that inflation is stubbornly at the low end of the bank’s 1-to-3% target range — 2% being the preferred level — and that the economy is growing at a disappointingly slow pace in the absence of stronger corporate investment, it looks like the 1% solution will be with us for a while yet.

After a strong rebound from the 2008-09 recession, the economy has slumped below its estimated annual potential of 2% growth. Last week, the Bank of Canada said it expects the output gap — the difference between potential and actual activity — to close by late 2015, when it also sees inflation, now at 1.1%, reaching the 2% target.

“The probability of a [rate] cut over the next six months could be as high as 20%,” Mr. St-Arnaud said in a report Wednesday.

Paramount, though, remains the health of household finances — with consumers still carrying record levels of debt — and a still-not-cool-enough housing market.

Lower rates would only heighten those concerns.

“The stabilization of the housing market may require further macro-prudential measures” to limit overall financial and economic risks, said Mr. St-Arnaud, based in New York, but who previously worked in Ottawa at the Bank of Canada and the Finance Department.

Jim Flaherty, Canada’s finance minister, has intervened in the housing market with stabilizing measures four times in the past four years. Most recently, in July 2012, he lowered the amortization period for government-insured mortgages to 25 years from 40 years, with the goal being to increase payment levels to discourage purchases by those least able to afford a home.

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“However, macro-prudential measures in the housing market are not the BoC’s mandate, and the government does not seem to be planning new measures, with the finance minister saying that

he has no intention of intervening in the housing market.”

So, without these measures being addressed, the likelihood is that the central bank’s trendsetting rate will stay put — as policymakers now insist — until early 2015, according to many economists.

And the heavy betting is still for that first move since September 2010 to be up, also likely by 25 basis points.

Even so, analysts at Capital Economics in Toronto have long argued that the Bank of Canada will need to cut borrowing costs instead.

“What we’ve seen over the last year or so is sluggish growth, a widening output gap and very subdued inflation. And that’s why we’re not surprised by the recent dropping of the tightening bias by the Bank of Canada,” said David Madani, at Capital Economics in Toronto.

“If there’s going to be any change in the policy interest rate over, let’s say, 12 to 18 months, I think it is more likely to be a cut than an increase.”

Pierre Siklos, professor of economics at Wilfrid Laurier University in Waterloo, Ont., said the bias “may be toward a rate cut but I doubt the bank will want to use any remaining ammunition just yet.”

“After all, we are not in crisis conditions,” said Mr. Siklos, who is also a member of the C.D. Howe Institute’s monetary policy council.

“The only wild card is continued weakness in the U.S. Economy, together with inflation rates nearer the lower bound of the target for over a year. If these factors continue into the new year — no sooner than the spring — then all bets are off about keeping the overnight rate at 1%.”

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