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Why the Bank of Canada’s talk of rising interest rates could stop

Bank of Canada Governor Mark Carney gives his opening address at the Vancouver Island Economic Alliance Conference in Nanaimo, B.C., Oct. 15, 2012.

CHAD HIPOLITO/THE CANADIAN PRESS

"This is going to be a very interesting policy announcement."

That's Michael Gregory, an economist at BMO Nesbitt Burns in Toronto, talking about Tuesday's policy statement by the Bank of Canada.

It's been a while since anyone has been able to say that about a Bank of Canada announcement. The central bank has been hunkered down with a benchmark interest rate of 1 per cent for two years.

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Governor Mark Carney caused a slight stir in April when the Bank of Canada inserted language in its policy announcement that indicated policy makers would like to raise interest rates sooner rather than later.

Six months on, the Bank of Canada finds itself as the only major central bank talking about higher borrowing costs. That talk could stop Tuesday. Most Bay Street and Wall Street economists think the Bank of Canada will end its latest policy deliberations with new forward guidance that will make clear that policy makers intend to leave the benchmark rate lower for still longer.

The announcement will be posted on the Bank of Canada's website at 9 a.m. Toronto time Tuesday. In the meantime, here's a primer on what to watch for:

What we know

The Bank of Canada's benchmark lending rate – the target rate for overnight loans between private lenders – will stay at the ultra-low setting of 1 per cent, where it's been since September, 2010.

Everyone from the International Monetary Fund to Caterpillar Inc. is cutting their economic outlooks. The Bank of Canada will be no different; Governor Mark Carney said as much last week when he told an audience in Nanaimo, B.C., that his revised forecast would reflect the extreme uncertainty that is paralyzing business investment around the globe.

In July, the Bank of Canada predicted third-quarter growth at an annual rate of 1.9 per cent, which is about as fast as policy makers think the economy can grow without sparking inflation. Instead, growth is tracking closer to a 1.5-per-cent rate, according to economists at Goldman Sachs. That means Canada's economy still has some ground to travel before it closes the "output gap," which is the difference between actual output and the central bank's estimate of non-inflationary growth.

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Speaking of inflation – there isn't much of it. On Friday, Statistics Canada reported that "core" prices – the bundle of costs, excluding food and energy, the central bank uses to gauge where inflation is headed – advanced 1.3 per cent in September from a year earlier, compared with the Bank of Canada's July forecast of an average of 1.9 per cent in the third quarter.

With the economy stumbling, and inflation tame, there is no case for an immediate interest rate increase.

What we think we know

If you believe in the wisdom of crowds, then you accept the Bank of Canada will drop any hint that it would like to raise interest rates.

Of the dozen Bay Street and Wall Street analysts that graciously send me their research on the Bank of Canada, all but a few predict a shift to more neutral forward guidance. The Canadian dollar has fallen by about a cent against its U.S. counterpart over the past week after Mr. Carney made no mention of the inevitability that borrowing costs eventually would be higher.

In April, the Bank of Canada introduced this line at the end of its policy statement: "In light of reduced slack in the economy and firmer underlying inflation, some modest withdrawal of the present considerable monetary stimulus may become appropriate, consistent with achieving the 2-per-cent inflation target over the medium term."

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A month later, the guidance was made more conditional: "To the extent that the economic expansion continues and the current excess supply in the economy is gradually absorbed, some modest withdrawal of the present considerable monetary stimulus may become appropriate, consistent with achieving the 2-per-cent inflation target over the medium term."

Andrew Tilton, Goldman Sachs's Canada economist, predicts any suggestion that interest rates could rise will be dropped Tuesday. Mr. Tilton noted on the weekend that the Bank of Canada cut its economic outlook in July, which in retrospect could be seen as a watering down of any bias toward raising interest rates. "In short, the Bank of Canada's tightening bias has been watered down repeatedly since its introduction, and we expect its removal (Tuesday) to complete that process," Mr. Tilton said in a note to clients.

What could surprise

There is some debate about how the Bank of Canada will word a neutral policy stance. Mr. Carney last week pledged to be as clear as possible in communicating the central bank's goals, and that has some analysts wondering if policy makers will suggest a calendar date for when interest rates might finally rise. This could have the effect of providing assurance that borrowing costs would stay low in the short term, while at the same time flash a warning light against taking on too much debt.

A few of the closest Bank of Canada watchers, including Avery Shenfeld, chief economist CIBC World Markets, say policy makers simply could opt to keep their current bias intact. The economic backdrop is weaker, sure, but it's not dramatically different than what the central bank foresaw in July, Mr. Shenfeld says. "The doves may be in for a disappointment," Mr. Shenfeld said in a note on Friday.

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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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