Bank of Canada's surprising signal of higher interest rates sends loonie higher

OTTAWA – A strong signal that Canadians could soon face higher borrowing costs was sent Tuesday as the Bank of Canada indicated it’s getting ready to raise interest rates based on improved prospects for the global and Canadian economies.

The hawkish statement took markets by surprise and immediately sent the loonie higher — it closed up 0.96 of a cent at 100.99 cents US.

As expected, the bank kept the trendsetting target rate at one per cent — where it has been since September 2010 — but it was the language in the accompanying statement that caught investors off guard.

“In light of the reduced slack in the economy and firmer underlying inflation, some modest withdrawal of the present considerable monetary policy stimulus may become appropriate, consistent with achieving the two per cent inflation target over the medium term,” it said.

Bank of Montreal economist Douglas Porter said he was surprised bank governor Mark Carney would send such a clear signal of intentions.

“I expected a slight turn of the dial to the hawkish side, but this was… a pretty serious amping up of the message,” he said.

“And more surprising was the signal that rates will soon need to rise.”

CIBC chief economist Avery Shenfeld said Carney prefers to give markets plenty of heads-up to any change in policy direction, so the announcement could point to a possible fall tightening at the earliest.

“I would interpret that as something on the order of three quarter-point hikes (to 1.75 per cent) and then followed by another pause.”

Still, both said nothing is written in stone, noting that Carney signalled higher rates last spring only to be dissuaded when the European debt crisis flared.

Some were even more skeptical. Capital Economics analyst David Madani said he suspects Carney may be trying to scare borrowers from taking on more debt.

“If the bank did actually raise rates, we suspect that it would have to reverse course again pretty quickly as the housing market slumped,” he said.

The reaction of the Canadian dollar to even a hint of future rates hikes also cannot give Carney much comfort.

The bank, as it has for many months, cited the strong dollar as a drag to economic growth. Raising rates will add more lift to the loonie, widening the spread with Canada’s major trading partner. That should weigh against making any more moves before the U.S. Federal Reserve moves to raise its own rates.

The counter to that argument is that Carney is dead serious when he calls household debt near a record 151 per cent of income the No. 1 domestic risk to economic recovery and has signalled he wants to discourage more borrowing.

In Tuesday’s announcement, the governor made clear that inflation is more of a concern than he previously thought, and that the economy is doing better, both of which would indicate a tightening cycle — if a modest and brief one — is approaching.

The bank now says the Canadian economy will likely expand by 2.4 per cent this year — four-tenths of a point faster than in its January forecast — and will return to full capacity in the first half of 2013, three-to-six months ahead of pace. It has, however, downgraded 2013 growth by the same amount to 2.4.

Essentially, the bank is expecting growth to happen faster, but not necessary be any stronger overall than its previous forecast.

Coincidentally, the International Monetary Fund also upgraded Canada’s growth outlook for this year by four-tenths of a point on Tuesday, although its expectation is more modest at 2.1 per cent, right on the consensus.

“Overall, economic momentum in Canada is slightly firmer than the bank had expected in January,” the Bank of Canada explained.

“The external headwinds facing Canada have abated somewhat, with the U.S. recovery more resilient and financial conditions more supportive than previously anticipated.”

According to the bank statement, the global economy has also improved and risks have moderated. Europe is now expected to emerge from the recession in the second half of this year, the U.S. growth profile is slightly stronger and economic activity in the emerging world is moderating but to a “still robust pace.”

Yet, Carney acknowledged that the improvements are modest and risks remain. The global economy is still underperforming and besides the usual suspects in debt-strapped Europe, he cited the high price of oil, caused by political turmoil in the Middle East, as a new risk factor confronting future growth.

“In particular, the international price of oil has risen further and is now considerably higher than that received by Canadian producers. If sustained, these oil price developments could dampen the improvement in economic momentum,” the bank cautioned.

For Canada, the bank said most of the future growth will come from domestic factors, with strong investments from businesses and robust household spending due to higher confidence and low interest rates.

Exports are likely to remain weak, the bank said, given soft external markets and the high Canadian dollar.