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Are central banks at risk of dangerously inflating asset bubbles by keeping interest rates too low for too long? That debate, which recently reached the discussion table at the U.S. Federal Reserve's Open Market Committee, has now taken a uniquely Canadian turn, in a paper published Wednesday by C.D. Howe Institute fellow Paul Masson. The economist asks a compelling question: if Canada's banks sailed through the credit crisis, liquidity here only dried up briefly, government debt levels are relatively low and our economy performed strongly compared to other developed economies, shouldn't the Bank of Canada start raising interest rates – now?
There was a strong case for the Bank of Canada to be part of a coordinated rate slashing exercise during the economic crisis, but would our central bank be wise to act on its own and raise rates? Certainly the bank has shown no desire to do so for the time being, citing slack in the Canadian economy, a muted outlook for inflation and "the constructive evolution of imbalances in the household sector."
Mr. Masson is right to point out that ultra-low rates have prompted Canadians to take on too much debt, pushed frustrated savers to take on riskier investments in pursuit of higher returns, punished insurance companies and pension funds and left taxpayers exposed to massive mortgage insurance underwriting risk by the Canada Mortgage and Housing Corp. Higher rates would moderate borrowing by the former and provide some relief to savers, while pre-emptively bursting the bubble now and heading off greater pain down the road, he says.
Of course, central bankers have shown little appetite for pricking bubbles in the past, preferring instead to mop up the damage afterward, as outgoing Bank of Canada Governor Mark Carney has pointed out. That doesn't mean the central bank wouldn't take actions to right growing financial instability – while remaining committed to its long-term inflation target of two per cent. "In exceptional circumstances, when financial imbalances pose an economy-wide threat or where imbalances themselves are being encouraged by a low interest rate environment, monetary policy itself may be needed to support financial stability," Mr. Carney said in a speech this month.
It's a tricky balance, so the question is, Have we reached a moment of "exceptional circumstances" where rate hikes are needed? Not yet. Inflation is low, unemployment is high – holding at a frustrating 7.2 per cent – and higher rates would choke an already a weak economy. Rising rates wouldn't help in another way, by pushing up the value of our loonie, hurting exporters. As for stopping the runaway housing market, the latest numbers suggest policy changes last year may have indeed had a moderating effect, setting up the hoped-for soft landing, and not something more dreadful.
Mr. Masson acknowledges all that, but hangs his argument on a U.S. economy that is picking up steam, saying the rising demand will benefit Canada and gives our central bank cover for raising rates. It sounds like a risky bet given the tentative state of the recovery south of border. But at least he's started a worthy discussion about just how long our monetary policy should move in lockstep with the U.S. There will come a day when central banks begin to manage the transition to tighter monetary policy, a monumental shift that could considerably disrupt markets. And if different economies emerge from their extended funk at various paces, we could well find the Bank of Canada moving at a different speed than the Fed.
Sean Silcoff is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights, and follow Sean on Twitter at @seansilcoff.
Sean Silcoff