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Canada’s credit bubble a central banker’s dilemma

Bank of Canada Governor Mark Carney was clear last week that the central bank will cut its economic outlook.


The Bank of Canada has a communications issue.

Canada's central bankers, who are set to update their policy stance on Tuesday and release a new assessment of the economy on Wednesday, must confront two serious economic threats that, under normal circumstances, demand opposite responses.

Governor Mark Carney was clear last week that the central bank will cut its economic outlook, acknowledging in a speech that extreme uncertainty over the prospects for the global economy has left investors and executives in a state of near paralysis. The new forecast will "take into account the uncertainty that I have been discussing today," Mr. Carney said in Nanaimo, B.C., on Oct. 15.

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In July, the Bank of Canada was counting on global economic growth of 3.1 per cent this year and next. The International Monetary Fund this month dropped its estimates to 3.3 per cent and 3.6 per cent, respectively, from 3.5 per cent and 3.9 per cent.

Weaker growth argues for easier monetary policy. Since the spring, the central bank has published guidance that it was inclined to raise interest rates sooner rather than later, saying the economy was steadily moving toward a level of output that risked sparking inflation. That moment surely has been pushed further into the future, suggesting the central bank could drop its guidance. Indeed, prices for financial assets linked to the Bank of Canada's benchmark rate shifted after Mr. Carney's speech, implying that investors think there is little chance borrowing costs will rise next year.

But here's the rub: Canada has a credit bubble.

The ratio of household debt to disposable income is 163 per cent, a level that exceeds that of the United States and Britain ahead of the financial crisis. "With debt where it is, the central bank knows the situation has to be brought under control," said David Watt, chief economist at HSBC Bank Canada.

For the better part of two years, Mr. Carney has been warning Canadians that ultra-low interest rates are exceptional; they will rise eventually, making home loans and credit lines more difficult to manage.

Finance Minister Jim Flaherty has pitched in by tightening standards for home lending, and the federal bank regulator called on lenders to back their mortgages with more capital. There is some evidence these measures are working: Sales of existing homes have declined by about 10 per cent since March.

But it's hard to judge whether this will last. The publicity around Mr. Flaherty's restrictions could have caused a temporary pullback. Once potential home buyers see the price of money remains near a once-in-a-lifetime bargain, they could rush back into the market. That would heighten the risk of a domestic financial crisis, as overstretched consumers could start to default on their loans en masse, forcing banks to retrench.

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"We could have a worse outcome if the central bank does nothing," Mr. Watt said.

What is to be done?

It seems the Bank of Canada has little choice but to adjust its messaging, an underappreciated aspect of monetary policy that often is forgotten amidst zero interest rates and multibillion-dollar bond purchases. "The recipe they have been trying has worn down," said Sébastien Lavoie, assistant chief economist at Laurentian Bank in Montreal. "They need to try to do something new."

In Nanaimo, Mr. Carney appeared to suggest he has been giving this some thought. "While we obviously cannot determine events over which we have no control, we can be transparent about what we expect and how we would react to different scenarios," he said. "That includes being clear about the role of monetary policy in supporting financial stability in Canada."

There was an assumption that the central bank's tilt toward raising interest rates was meant to dissuade households from taking on more debt. Mr. Carney corrected that assumption last week, saying that if the central bank opted to "lean against the wind," it would say so directly. In that spirit, Mr. Lavoie said the central bank could potentially achieve its policy goals by setting out a path for interest rates over the next few years based on a few plausible scenarios of how the economy could unfold, rather than simply discussing a base case. That would give households a clearer idea of borrowing costs in a few years' time if the threats keeping interest rates low were to dissipate. Such an approach also could spur business investment by inspiring executives to take advantage of low rates before they are gone.

Mr. Lavoie, a former Bank of Canada economist, concedes that his suggestion would be a bold step. "Are they ready to be innovative?" he said in an interview. Mr. Lavoie could get his answer this week.

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About the Author
Senior fellow at the Centre for International Governance Innovation

Kevin Carmichael is a senior fellow at the Centre for International Governance Innovation, based in Mumbai.Previously, he was Report on Business's correspondent in Washington. He has covered finance and economics for a decade, mostly as a reporter with Bloomberg News in Ottawa and Washington. A native of New Brunswick's Upper St. More


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