Mark Carney, Governor of the Bank of Canada, will convene the Board of Governors meeting on June 1 to decide whether or not to increase the overnight rate from its current emergency level of .25%. Over the past several months we have had bank economists forecasting rapid rate increases, calling a hike at the June meeting “a virtual lock”, with traders too betting heavily on increased rates. Long-term rates shot up last month, only to reverse ground a few weeks later. With so much volatility and so many competing forces, Mr. Carney’s upcoming decision may become the defining moment of his governorship. So should he zig or should he zag?
The Bank of Canada’s single most important objective is to control inflation or, as Mr. Carney put it, “to provide Canadians with confidence that their money will retain its purchasing power”. His main policy instrument is the overnight bank rate, which sets the rate used by banks to lend each other money over the very short term – literally overnight. Since all other short-term rates are based on the overnight rate, when it moves, it sends ripples across the entire short-term borrowing spectrum. (Note: the central bank does not directly control long-term rates, which are determined by the bond market.) The lower the rate, the more money is available to flow into the economy, so think of it as a tap that controls the rate of liquidity.
Our current overnight rate is at emergency levels in response to the global credit crisis which began in 2007 and is ongoing. Like all central banks, ours opened their liquidity tap as wide as they could and flooded the market with cheap money. The overnight rate was lowered from 4.5% in August, 2007 to .25% by April, 2009, when Mr. Carney also took the unusual step of telling the markets that the liquidity tap would remain open until at least June, 2010. He used enough caveats to leave the door open a smidge but from a guy whose words can and do move the markets, this was as close to a guarantee as you could expect to get.
Since that day, the markets have used this extra money, or stimulus, to good advantage. As a result, the storm clouds in the Canadian economy are dispersing and signs of recovery abound. But the economy is complex and while the flood of liquidity was positive overall, it also added fuel to an already hot housing market and helped consumer debt expand to record levels. Last month, as inflation seemed to be returning, the market priced in an immediate increase with others to follow. But then housing started to cool on its own, and Mr. Carney had to worry that increasing the cost of borrowing prematurely could easily stifle our still nascent recovery…especially as the world still shudders around us.
When we focus on Consumer Price Index numbers and job reports we see the momentum in our domestic economy, but when Mr. Carney surveys our trading partners, he can’t like what he sees. To put things in perspective, Canada accounts for 3% of the world’s GDP and our largest trading partner, who buys around 80% of what we sell, is getting up off the mat with some doubt as to whether it will be broadsided again. The emerging markets (most worryingly China), who many feel can support our commodity-based economy while the US recovers, are also showing signs of slowdown. And that’s saying nothing of Europe. How long can Canada thrive in the absence of a global recovery? Will raising rates slow the precious momentum so essential to us as we wait for global growth to return?
In my view, it’s a good news, bad news scenario. The good news is that I don’t think that Mr. Carney will be raising rates on June 1 or anytime soon (beyond a symbolic level). I think he will take more time to see whether the housing market stabilizes on its own and to observe the impacts of the new high-ratio mortgage rules as well as the introduction of the HST in Ontario and British Columbia. The bad news is that he will do this because emergency measures are still warranted in the face of global economic uncertainty. So we can keep enjoying our variable-rate mortgages – while Rome burns.