Thursday, June 19, 2008

More Evidence Rates to Stabilise and then Rise

Hi All,

This is an interesting article on the Bank of Canada Governor's defense of his decision to not cut rates over the last few weeks. Like I mentioned in my earlier post on high fuel costs, higher fuel prices are beginning to pinch and the Bank of Canada sees inflation as a threat and that threat is dealt with by raising interest rates. The question is how much and when!

I'd love to hear your thoughts!

Carney defends decision on rates

Globe and Mail Update

CALGARY — Bank of Canada Governor Mark Carney says he needs to maintain a “relentless focus on inflation” during this period of soaring commodity prices to avoid a repeat of the painfully high inflation and unemployment that marred Canada's economy in the early 1980s.

In his first speech since the central bank abruptly switched direction last week and put a halt to the steep interest rate cuts of the past few months, Mr. Carney explained in detail why he could no longer justify adding stimulus to Canada's stagnant economy.

“In the face of the largest commodity price shock in our lifetimes, we cannot be complacent,” he said. “While commodity price shocks raise complex issues, a relentless focus on inflation clarifies policy decisions, makes communications easier and maximizes the likelihood that expectations will remain well anchored.”

Canada's economic activity contracted during the first quarter of 2008, and inflation has remained low and steady, despite soaring energy prices. In May, total inflation increased 2.2 per cent from a year earlier, but core inflation – which excludes the most volatile prices such as energy and some types of food, and is the focus of the bank's monetary policy – was a benign 1.5 per cent, Statistics Canada said Thursday.

The combination of a slowing economy and low inflation had led many economists to expect the central bank to continue cutting rates. The central bank has already lowered its key interest rate from 4.5 per cent to 3 per cent since December.

But Mr. Carney, speaking at a conference titled “Commodities, the Economy and Money” sponsored by the Haskayne School of Business at the University of Calgary, the Bank of Canada and The Globe and Mail, avoided the topic of low growth on Thursday. Instead, he reminded his audience that inflation-fighting is the single priority of the central bank.

During the 1970s, he said, central bankers made a major mistake in cutting interest rates too far to help consumers deal with rising oil prices. At the same time, governments boosted spending as if the extra revenues they were pulling in from high profits in the oil patch would last forever.

“The fallout from these errors in monetary and fiscal policy was severe,” Mr. Carney said. “The global recession of 1981-82 was, in large measure, the end result.”

Canadian inflation and unemployment soared to double digits by the early 1980s, and took years to unwind, he recalled.

Recently, the Canadian economy has been rocked by the U.S. slowdown and financial market turmoil, but the central bank now needs to focus on the effects of rising commodity prices on the Canadian economy, he said.

He pointed out that commodity prices have risen higher than expected – indeed, Mr. Carney had been predicting that they would fall. Since Canada is a major commodities producer, the higher prices will support domestic demand in Canada, as oil and gas revenues flood into the country.

Plus, global growth – and hence, global inflation – has been higher than expected, pushing up the cost of Canadian imports. At the same time, the anti-inflation shield provided in the past year by a rising Canadian dollar is eroding as the currency has stabilized.

And the effects of the credit crunch have improved significantly in Canada, Mr. Carney said.

“This evolution of the global economy and domestic demand was sufficient to alter the view” that Canada needed further rate cuts, the governor said, suggesting the central bank would keep rates on hold for now.

That means the commodities boom, which has been great for Canada, will continue to be beneficial, Mr. Carney argued.

“We are experiencing a commodity supercycle,” he said, during which commodity prices have risen further and stayed high longer than in previous booms.

“Above all, rising commodity prices have made Canada wealthier as a nation,” creating good jobs across Canada and boosting the country's income.

Many economists have argued that rising commodity prices have seriously harmed Central Canada's manufacturing base, and warn that Ontario is on the brink of a recession.

But Mr. Carney said the “stress and dislocation” caused by high commodity prices is unavoidable, and prompts economies to adapt to a more efficient allocation of resources.

The Governor hinted, however, that policy makers need to make sure they don't fritter away the proceeds of the boom, referring twice to a popular bumper sticker seen frequently in the oil patch 20 years ago that reads: “Dear Lord, give us another oil boom and we promise not to piss this one away.”

He predicted that energy prices would remain high, since demand in emerging markets is strong, and the supply response has been “disappointing.”

While commodity prices won't necessarily rise persistently, “this appears to be a durable relative price shift,” Mr. Carney said, adding that there is no clear-cut evidence that speculation is creating a commodities bubble.

But eventually, consumers will find cheaper alternatives, and production costs will come down through the adoption of new technologies.

“Demand and supply will adjust, particularly as prices are passed through.”

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