Canada Sings Out of Tune

08/02/2010 12:01 am EST

Focus: GLOBAL

Gordon Pape

Editor and Publisher, The Income Investor and the Internet Wealth Builder

The latest rate hike is at odds with the slowing economy and policies in other developed countries, writes Gordon Pape in the Internet Wealth Builder.

What's wrong with this picture? The Bank of Canada raises interest rates again even while admitting economic growth is slowing and recovery in the rest of the world is tentative at best.

Meanwhile, in Washington, Federal Reserve Board Chairman Ben Bernanke tells the Senate Banking Committee that the outlook for the US is "unusually uncertain", a worrisome choice of words—to say the least.

The Fed has access to more economic intelligence than probably any other body in the world. When its leader essentially throws up his hands and admits he hasn't a clue about where things are going, it should set off alarm bells everywhere.

Of one thing he is certain: The Fed isn't going to raise interest rates any time soon. The federal funds rate is effectively zero, and Mr. Bernanke told the senators that he "continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

So, why are we raising rates in [Canada]? It's not as if the Canadian economy is overheating and inflation is looming. In fact, Statistics Canada [recently] reported that the rate of increase in the Consumer Price Index is actually decelerating.

The June figure for the previous 12 months came in at 1%, down from 1.4% in May. On a seasonally adjusted monthly basis, consumer prices actually fell 0.2% in June. The Bank of Canada's core inflation rate, which excludes energy, tobacco, and certain foods, also slowed slightly, coming in at 1.7% annualized compared to 1.8% in May.

Clearly, inflation is not a pressing concern. Neither is runaway growth. In the statement that accompanied the rate hike announcement, the Bank of Canada described the global economic recovery as "proceeding but is not yet self-sustaining". Moreover, it admitted that austerity programs, which it euphemistically described as "balance sheet repair," will slow the pace of growth relative to earlier projections.

The result, the Bank said, will be a steady deceleration in Canada's growth over the next two and a half years, from 3.5% in 2010 to 2.9% next year and 2.2% in 2012. "While employment growth has resumed, business investment appears to be held back by global uncertainties and has yet to recover from its sharp contraction during the recession," the Bank noted. Indeed, Governor Mark Carney did not rule out a double-dip recession, although he described it as a "low probability."

So, why increase rates in these circumstances? The [official] statement offered no clear rationale for an interest rate hike at this time. All it says is that the decision reflects "all of these factors", referring to domestic and global economic activity and the inflation rate. But none of those factors screams for a rate increase.

There is no doubt that we are out of step with the rest of the developed world on this, and even modestly higher interest rates could have far-reaching effects. For example, a widening gap between our rates and those of the US will put upward pressure on the value of the loonie, which won't help our exporters. If oil prices remain stable, the Bank's decision has increased the possibility that [the Canadian dollar] will be back at par with the US dollar before year-end.

Unless the US economy starts showing signs of a more robust rebound, it's difficult to see how any further rate increases this year can be justified.

The Bank of Canada's next rate decision is on September 8th. If the economic outlook has not improved by then, let's hope Mr. Carney and friends have the good sense to leave the target overnight rate alone—as I think they should have done this time around.

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