BoC remains on hold as inflation fears rise

BREAKING NEWS FROM THE GLOBE AND MAIL

KEVIN CARMICHAEL

Tuesday, July 15, 2008

OTTAWA — The Bank of Canada left its benchmark interest rate at 3 per cent and predicted raging oil and food prices would cause inflation to surge past 4 per cent by early next year.

Governor Mark Carney and his five deputies on the governing council also cut their estimate for economic growth for 2008 to 1 per cent, which would be the weakest in almost two decades, citing “protracted weakness” in the U.S. economy and “ongoing turbulence” in financial markets.

The central bank’s decision to leave borrowing costs unchanged suggests Mr. Carney’s biggest concern is keeping a lid on Canadians’ expectations about prices. Policy makers raise and lower interest rates to keep inflation advancing at an annual rate of 2 per cent and are uncomfortable with prices advancing any faster than 3 per cent.

“Commodity prices are continuing to outstrip earlier expectations,” the Bank of Canada said in its statement today in Ottawa. “This has led to further increases in Canada’s terms of trade and real national income, and has altered the outlook for global and domestic inflation.”

There was little immediate reaction in financial markets as most investors and economists were expecting the Bank of Canada to leave interest rates unchanged. In the flurry of research notes that followed the central bank’s decision, economists said Mr. Carney is handcuffed by weaker growth and bubbling inflation, leaving him little choice but to stand pat.

“Overall inflation is growing concern for the Bank of Canada, but the bank’s growth worries will keep a hold on rates for the time being,” said Meny Grauman, an economist a CIBC World Markets in Toronto.

Win Thin, a currency strategist at Brown Brothers Harriman & Co. in New York, said the futures market for Overnights Index Swaps, where values are based on the underlying interest rate, suggests investors expect the Bank of Canada to lift borrowing costs by no more than a quarter point over the next 12 months, compared with expectations of a three-quarter point increase as recently as mid-June.

In its statement, the central bank called the risks to its outlook “balanced.”

The Bank of Canada also left its benchmark interest rate – the target it sets for overnight loans between banks – unchanged at 3 per cent at its last policy meeting in June, a move that surprised market players.

Before that announcement five weeks ago, policy makers had slashed their key rate by 1½ points over four decisions dating back to December, a campaign aimed at offsetting slumping U.S. demand for exports and the global credit crunch.

The priority now is persuading Canadian business owners and workers that their central bank will keep inflation from burning out of control.

One of the biggest worries at the central bank is that companies will start charging higher prices to compensate for higher commodity prices and workers will demand higher wages, sparking an inflation spiral.

There is some evidence this might already be happening. The central bank’s July survey of businesses showed 36 per cent of the companies expected inflation will climb above 3 per cent, compared with 17 per cent in April.

Policy makers stressed in their statement today that total inflation’s burst to 4 per cent in the first quarter of 2009 will be temporary. They predicted energy prices will stabilize, allowing inflation to ease back to 2 per cent by the second half of next year.

Canada’s economy hasn’t grown slower than 1 per cent since it advanced 0.9 per cent in 1992, one year after a recession, according to International Monetary Fund data.

Still, the central bank said little has happened to change its longer term growth outlook. Higher prices for exports, relatively low interest rates and a “gradual recovery” in the U.S. will spark a Canadian rebound starting early next year, the Bank of Canada said.

The central bank shaved its growth estimate for 2009 to 2.3 per cent from 2.4 per cent and left its projection for 2010 unchanged at 3.3 per cent.

The Bank of Canada will expand on its current thinking on the economy when it releases an updated policy report on Thursday. The central bank next meets to consider its benchmark interest rate on Sept. 3.