Rate hike not a certainty
In 2007, when the credit crisis hit, and began to broaden into a wide-spread meltdown affecting financial markets and the global economy – the world’s central bankers acted swiftly and in a coordinated fashion. It was this coordination that dampened the recession and limited the potential catastrophe, and it is often cited as the reason that it was less severe than the Great Depression.
The greater challenge lies ahead of us – how to coordinate the withdrawal of support. Global governments intervened to prop up their financial institutions. It should not come as a surprise that some governments did not have the finances to weather the storm for long (see PIIGS- – Portugal, Ireland, Italy, Greece, and Spain). Their actions did not eliminate the problem, but dispersed it and delayed its effects. The buffer of currency exchange fluctuations has been eliminated in the EU, forcing stronger countries to support weaker ones. In the old model, the drachma would have been devalued to reflect heightened risk, and Greek goods and services would have dropped in price stimulating trade and foreign investment. Note that Canadians see the reverse of this with a strong dollar against the US as a result of a healthy Canadian economy.
Ironically, the uncertainty this has caused has driven investors to the safe haven of the US dollar – the market where it all began. Uncertainty has caused market weakness and volatility. As of this writing, the TSX has fallen another hundred points, the Canadian dollar is below 96 cents, commodities are down, and the specter of rising interest rates are making bonds less attractive.
Interest rates hikes serve to dampen economic activity and reduce inflation. Here is what you cannot do with monetary policy – fix deflation. If consumers expect prices to be lower next year, they will delay their purchases regardless of current or expected interest rates. This becomes a self-fulfilling prophecy as slowing economic activity encourages belief in future price reductions.
Although economists are predicting a rise in the Bank of Canada’s overnight rate June 1, here are the reasons to be skeptical:
- The consensus estimate for April’s core inflation rate (to be released by Statistics Canada on Friday) is 1.8 per cent – below its 2 per cent target rate
- Last year Mark Carney promised to hold rates steady until July 20, 2010
- The rest of the world is still reeling, and removing economic stimulus now would be out of line with other Central Bank activity (with the notable exception of Australia)
- On May 5, 2010 Statistics Canada release revealed that Canadian investors held $585.6 billion in foreign securities at the end of 2008, and the value of these assets fell 23.4 per cent from a year earlier (see http://www.statcan.gc.ca/daily-quotidien/100507/dq100507b-eng.htm) ; capitalization ratios of financial institutions would be under additional pressure if assets are devalued by weaker markets and increased interest rates
- Equity markets are nervous and are looking for stability
- Increasing interest rates here would lead to a stronger Canada/US exchange rate and hurt industries that rely on exports
