From today’s Toronto Star business section. Hold on to your mortgage, folks. The Liberal budget legacy could be explosive.
Budget raises rate fears
STEVEN THEOBALD
BUSINESS REPORTER
The federal budget packs so much fiscal spending oomph for the economy that the central bank may be forced to start hiking interest rates sooner and higher to prevent inflation pressures, some economists are warning.
“This budget will have created the perverse effect of generating higher interest rates,” warns Marc Lévesque, chief strategist at TD Securities.
The Bank of Canada, which next sets interest rate policy tomorrow morning, must now consider a government spending package that will add about 0.4 per cent of gross domestic product this year and 0.5 per cent in 2006, Lévesque said. “It’s a significant fiscal kick — the largest we’ve had in a long time — and there are consequences to that,” he said.
“If the economy wasn’t operating so close to capacity it wouldn’t matter because the bank could just sit back and let growth rip.”
He still expects the central bank will wait until the fall to start raising its trend-setting overnight rate, but the increase may now come in September rather than October.
By the end of 2006, the overnight rate could be an extra half point higher than previously expected — 4.5 per cent versus 4 per cent — because of the added government spending, Lévesque said.
The Bank of Canada has held its overnight lending rate at 2.5 per cent, citing concerns the strong Canadian dollar is hampering the export sector.
Short-term commercial loan rates, such as the prime lending rate and variable-rate mortgages, tend to be more in lockstep with the overnight rate. Longer-term interest rates are set by bond markets, which are indirectly influenced by the overnight rate.
All 12 banks and brokerages surveyed by Dow Jones on Friday expect the central bank will again leave rates unchanged tomorrow. Looking ahead, the spendthrift budget all but locks in a quarter-point rate hike on the following policy setting day, July 12, predicted Michael Gregory, a senior economist with BMO Nesbitt Burns.
He expects tomorrow’s policy statement from the central bank will set the stage for a July move by taking a more hawkish tone.
“With the two budget bills passing, the Canadian economy is going to soon start feeling the benefit of the additional fiscal spending.”
With the unemployment rate near a 30-year low and capacity utilization rates at a 16-year high, the economy doesn’t have a lot of room to absorb all that extra government spending without creating inflation pressures, Gregory added.
“So we believe the bank, given what they do, will be raising interest rates sooner rather than later.”
CIBC World Markets represents the pessimists’ camp. It believes the central bank will not be raising interest rates any time soon, and certainly not this year.
A big-dollar federal budget isn’t changing that point of view, said Avery Shenfeld, CIBC senior economist.
“Fiscal policy and monetary policy are both providing stimulus, but all the evidence shows the Canadian economy needs every ounce of it.”
Conversely, analysts at National Bank Financial argue the added fiscal stimulus together with a softening dollar and upbeat U.S. economic data could prompt the central bank to raise its growth forecast.
“Given the Bank of Canada’s assumption about the current level of the output gap — virtually non-existent — and its concern about the lack of productivity growth in Canada, it wouldn’t take much of an upgrade to prod the bank into action at its July meeting,” NBF assistant chief economist Stéfane Marion wrote in an email to clients.
Andrew Pyle, senior financial markets economist at the Bank of Nova Scotia, takes a much more skeptical outlook.
The economic situation is precarious because of a slowing world economy and falling commodity prices, he says. With inflation not posing a threat, the central bank ought to stay on the sidelines for the foreseeable future, he suggests.
“Not only is there no room for near-term interest rate hikes, but the argument in favour of eventual tightening is also losing its validity.”
1 comment so far ↓
“the economy doesn’t have a lot of room to absorb all that extra government spending without creating inflation pressures”
If unemployment in Canada is very high (7.2% versus less than 6% in the USA), how can it really be said that the economy is anywhere ‘near capacity’?
Probably one of the big downfalls of the Bank of Canada, compared to the system in the United States, has been keeping interest rates far too high in a misguided attempt to constrain economic capacity. This has produced high structural unemployment (compared to the USA), low wages, and low levels of productivity compared to those experienced in the US.
It really is a Canadian tragedy that our central bankers honestly believe economic ‘capacity’ is a static thing, and that one must be very careful not to encroach on its supposed ‘upper limits’. If there was ever a ‘capacity’ shortfall in Canada, no doubt, increased productivity, increased immigration, or increased utilization of natural resources could make up the gap. Look at Japan — they have no natural resources, very little land, yet they have managed to build and sustain an economy many times the size of Canada. With Canada’s resources, why can’t we do 5X better than Japan? Its because our politicians keep relying on bad economic ‘theory’.