Raising the interest rates

Governor Mark Carney has become the first central banker in the Group of Seven to raise interest rates since the financial crisis and recession began in 2008. His anticipated decision was published on Tuesday - to raise the central bank’s overnight rate by one-quarter of a percentage point to 0.5 percent after more than a year at a record low level.

The Bank of Canada noted that inflation is unfolding as expected and that spill-over from the European debt crisis has been limited, but stressed that uncertainty still remains uncertain about the global recovery.

Benjamin Tal, Senior Economist of CIBC, told Shalom Life that no economic recovery goes in a straight line, and promised that the current one will be the most non-linear of them all: “As in the U.S., many of the chief drivers of the Canadian recovery will run out of fuel by mid-year, and will give way to sub-par growth in the second half of the year.”

Tal referred to the hike as a first step in a potential future trend. “While the bank of Canada started to hike rates, it appears much less certain about its next move, clearly realizing the non-liner nature of the recovery and the negative impact of increased uncertainty regarding the situation in Europe,” said Tal. “Add to it the fact that the bank is flying solo without the fed and you have a recipe for a very gradual approach by the bank. Overall, I expect the rates to rise by 75-100 basis points by year-end.”

This week, Canada statistics published the impressive numbers for the first quarter, a growth of 6.1 percent. Tal emphasized that this increase was built on a nearly 5 percent growth in the previous quarter. “The 3.5 percent GDP growth projected for 2010 as a whole will mask two opposing trends,” Tal predicted, “as the euphoric performance of the first half will give way to a much more subdued second half, which will see growth decelerating below the two percent mark”.

He also noted that exports are still surging ahead, aided by a rebuilding of domestic inventories and the similar restocking of inventories in the U.S. “This led to an impressive 18 percent (annualized) improvement in the quarter in manufacturing activity. As well, fueled by low interest rates, consumption rocketed ahead, and residential construction put in its second consecutive quarter at more than 20 percent annualized growth.”

The 2009 demonstrated, as Tal underscored, that an initially V-shaped recovery can easily turn into a flatter U, if the rest of the world doesn’t measure up. He expressed an array of limiting factors, including a strong dollar, the end of fiscal stimulus, a slower pace of economic activity in the U.S., and a more rate-sensitive household sector, to influence a slower economic growth in the second half of the year.

The Eurozone caused the markets to tremble on the last couple of weeks, but Tal noted that the slowing European economy is not a big story outside of Europe. “A stagnating Eurozone will clearly hurt European countries, even those outside of the EMU, such as the UK and Russia,” said Tal. “But looking beyond Europe, the damage should be less dramatic.”

He quoted that less than a fifth of exports from leading emerging markets such as China, India and Brazil go to the Eurozone.

Regarding Canada, Tal put the numbers at the forefront of the discussion. “Unlike the tie to the US,” he said, “when Europe sneezes, Canada does not necessarily catch a cold. That’s because trade linkages between Canada and the old continent are not as vital as the ones we have with the US. The Eurozone’s 16-member nations account for four percent of total Canadian exports (or eight percent for the EMU and the UK combined). Arguably, slower demand from Europe could be more than made up by higher demand from elsewhere.”

Tal concluded that the rescue package provided by the EU and the IMF shows that this kind of economic risk has been postponed by a year or two. For now, there are other challenges to deal with.