Strategy

Does Mark Carney know what he's doing?

His deft handling of the financial crisis made him the darling of global banking. But now that the time has come to raise interest rates, he’s hesitating—and it’s threatening everything he’s achieved.

Bank of Canada Governor Mark Carney (Photo: Deborah Baic/The Globe and Mail)

On Oct. 23, Bank of Canada governor Mark Carney will set his target for the overnight interest rate. There will be no surprises. Carney will leave it at 1%, where it has sat for just over two years. What economists and businesses will watch for instead is guidance on where he will move rates in the future, hunting for any sign he’s preparing to raise them.

Raising them is precisely what he should do. Some argue he should have done so already. In the history of the country, interest rates in Canada have never been this low for this long, and it’s putting us on shaky ground. Low interest rates were necessary to juice the economy during the financial crisis, but they are now, by many measures, doing more harm than good. Cheap credit has caused a host of problems: it has blown out household debt and inflated home prices in some markets to unsustainable levels. Meanwhile, laughably low interest rates are punishing individual savers—especially the ones who have been most careful and conservative. On top of that, with bond yields languishing, insurers and pension funds are finding it difficult to meet their savings obligations.

“We’re in a seriously dangerous situation,” says Michael Parkin, professor emeritus at Western University. “We have no exit strategy from these low interest rates.” Combined with the loose-money policies at all the major central banks, high inflation is an increasing risk. “We are going to see serious inflation unfolding, and Canada is not going to escape it,” he says.

Carney is admittedly caught in a difficult spot. The Canadian economy is still weak. Our major trading partners, the United States and Europe, are in dismal shape. If he moves too soon or too fast, he chokes off the supply of cheap credit to consumers that’s helping drive our economy. If growth stalls, we’re on the brink of another recession. The U.S. Federal Reserve has also backed him into a corner. Its recent commitment to keep rates low until employment improves substantially means Carney can’t raise rates without sending the dollar higher, bruising manufacturers.

These are real concerns, but the price of hesitation may be even higher than acting too soon. “The bank has been too timid,” according to Thorsten Koeppl, an associate economics professor with Queen’s University. “We have to raise interest rates to get to a neutral level.” Given the bank’s goal of 2% inflation, a normal rate of interest would be at least 4%. That is a crazy proposition in today’s low-growth world, of course. A more reasonable level for Carney to reach over the next two years is closer to 3%, Koeppl says, to keep ahead of inflation and reduce the negative effects of low rates. The key is to do so slowly, gradually and with plenty of notice beforehand. “I actually don’t think the bank’s opinion is that different from mine of where the interest rates have to be,” he says.

That seems to be true: Carney’s frequent warnings about debt and the housing market shows he is well aware of the risks. But by talking instead of acting, he also runs the risk becoming another Alan Greenspan, the once infallible guru who infamously stuck to low interest rates and ignored the massive debt and housing bubble he helped create until it was too late. Greenspan’s legacy is now tarnished. It’s hard not to wonder if, a decade from now, we might look back at Carney in a similar way.

Today, Mark Carney is the golden boy of international finance—and for good reason. He’s intelligent, genial, and has the rare ability to talk about monetary policy in terms people can understand. Most important, he made all the right moves during the financial crisis, slashing rates to prevent a crushing recession. His reputation is stellar overseas, too. Last year, he was named head of the international Financial Stability Board. Rumours later swirled that the Bank of England wanted to poach him from Canada. Back home, Liberal party members were elated when he was recently touted as a possible leadership contender (a notion quickly quashed by the central bank). Everyone, it seems, wants Carney to solve their problems.

The infatuation is premature. The height of the financial crisis was the easy part for Carney. Cutting rates was a co-ordinated action by central banks around the world, and it was fairly obvious the Canadian economy would need stimulus. Carney arguably had an easier time than other central bankers because our financial system was stronger to begin with. The true test of his ability is yet to come: how does he get us back to normal?

He’s left the overnight rate at 1% since September 2010, a level that even he has indicated is unusual. “The Bank of Canada doesn’t like being in this position. I’m sure they want higher rates,” says David Madani, an economist with Capital Economics. Carney was practically itching to raise them last April. His normally boilerplate explanation for his interest rate decision contained a new line: “Some modest withdrawal of the present considerable monetary policy stimulus may become appropriate.” (This is what passes for strong language in the world of central banking.) Some economists were surprised at the time by his newly hawkish stance. But he’s since backed down again, in part due to uncertainty in Europe.

Meanwhile, he is seriously worried about the side effects of low rates, repeatedly citing household debt as the biggest domestic risk to Canada. Households have an average debt load of 154% of income, according to Statistics Canada. Twenty years ago, that figure stood at only 95%. Canadians aren’t just using cheap credit to take on mortgages, either. The average non-mortgage debt reached $26,221 in the summer, the most in eight years, according to TransUnion. Car loans accounted for most of the recent increase.

What’s particularly worrying is that since the financial crisis, more households are veering toward extremes. Benjamin Tal, an economist with CIBC, reported in a study earlier this year that heavy borrowers, those with household debt-to-gross income ratios above 160, accounted for 34% of all borrowers compared to 26% in 2007. That group now holds an astounding 70% of outstanding debt.

Carney’s approach has been to bleat warnings about the perils of too much debt, a stance that lacks credibility so long as he keeps rates low. How can he tell Canadians not to borrow more when everyone knows he pushed rates down and kept them there in a deliberate effort to get Canadians to borrow more? Few households are listening, in any event. The longer Carney keeps rates low, the bigger the problem gets.

The same is true of the housing market. Canadians are taking advantage of low rates to buy real estate, leading to a huge surge in home prices. Carney warned as early as last year that many cities in Canada are “severely unaffordable” and there is a “possibility of an overshoot” in condo markets. In a June 2011 speech in Vancouver, he pointed out that some real estate markets are at risk of being driven by not just supply and demand, but “greed among speculators and investors, and fear among households that getting a foot on the property ladder is a now-or-never proposition.” The federal government and the banks hold considerable sway over the housing market, of course; the central bank’s benchmark rate is a clumsy tool for trying to moderate volatile real estate markets. But low interest rates are still the catalyst for people to act on the very greed and fear that Carney railed against.

Madani with Capital Economics is firmly predicting a hard landing, given how far the market has been allowed to overshoot. “When all the dust settles five or 10 years from now, I think we will look back on this and realize rates were too low for too long,” he says. Carney had room to tighten past 1% back in 2010, according to Madani. That may have reduced some, certainly not all, of the exuberance for debt and real estate.

While the fate of borrowers and the housing market are concerns for the future, there are already people suffering today as a result of low interest rates: savers and retirees. The conservative investments, such as government bonds, favoured by baby boomers and retirees are producing virtually nothing, as today’s low rates demolish returns. The yield on a 10-year Canadian government bond is just 1.7%, compared to more than 5% a decade ago. Today’s returns can barely keep pace with inflation. Sun Life Financial CEO Dean Connor highlighted this problem at a speech in Toronto in October. Five years ago, a Canadian earning an 8% return on a portfolio would need to invest $180,000 to generate $20,000 a year for life after age 65, he noted. At 5%, which is more in line with today’s returns, that person would need to invest $230,000—30% more. “How does a retiree manage that?” he asked. “You can hope interest rates go up, put off retiring, scale back your retirement plans and spending, or take more investment risks. None of these are great options.”

Connor is not an impartial observer. Low rates are hammering insurance companies, reducing the projected return on their investment portfolios. Those portfolios are used to guarantee future payouts to policyholders. If the value declines, companies have to hold more assets to meet their guarantees, putting a huge dent in the bottom line. Sun Life recently estimated it could take a $600-million hit to earnings by 2015 if rates stay low.

Pension funds have a similar problem. Low rates are contributing to massive funding shortfalls. The calculation used to determine a fund’s solvency rate is based on the yield of long-term government bonds, which are at rock bottom. The lower the return on bonds, the more assets a fund needs to hold to ensure members can be paid off.

Mercer, a pension advisory firm, estimates 94% of plans are underfunded. “Pension plans feel there’s a lot of manipulation in the system right now,” says Manuel Monteiro, a partner with Mercer. The belief is that because rates are being kept artificially low, then the pension deficits are also artificially and temporarily large. As a result, companies are reluctant to make additional contributions. “Because plans are in a big deficit position now, some companies are really counting on interest rates to go up,” he says.

So with such a range of problems today—not to mention the severe risks down the road—what’s stopping Carney from acting?

In statements supporting his rate decisions, Carney typically cites a weak domestic economy, stable inflation expectations, and a hugely uncertain picture globally, all of which are perfectly valid and worthy of caution. Despite all of this, some say tightening is necessary.

The Canadian economy may not be roaring, but it is growing. One metric the Bank of Canada employs to assess the economy is the output gap—a measure of the country’s actual gross domestic product compared to its potential. That gap is narrowing ever so slowly as the country returns to capacity. “If you’re going to have output coming back to potential, you’re going to want interest rates back to some normal level,” says Chris Ragan, an associate professor of economics at McGill University.

The central bank also employs confidence surveys to gauge how businesses are feeling about the economy. Understandably, businesses are not terribly optimistic. But the central bank itself is partly to blame, argues Michael Parkin at Western University. Carney hasn’t given a clear enough indication of how and when he intends to tighten, only to say it will happen—eventually. Businesses respond to that uncertainty by hoarding cash rather than spending, something Carney recently criticized. Much like he has the power to stop Canadians from burying themselves in debt, he can also encourage businesses to spend, Parkin argues, by announcing intentions to tighten. “It would just remove the huge fear and uncertainty about what comes next, and I think we’d see business investment picking up,” he says.

What if another economic calamity happens, such as Greece leaving the eurozone? Some fear the Bank of Canada will lose credibility if it’s forced to reverse course. But most people are smart enough to recognize the world is unpredictable. A central bank that takes the right steps in response to unexpected events should actually engender confidence. Carney could also clearly communicate he’s aware of the risks abroad, lest anyone think he’s turned into a pie-eyed optimist. “If the bank were to state specifically that there are downside risks in Europe but we can’t sit around and wait forever with rates where they are, I don’t think people would be surprised if the bank has to turn around due to an unexpected event in Europe,” says Steve Ambler, an economics professor with the Université du Québec à Montréal. In fact, if rates were a little bit higher, Carney would have more room to cut them again to stimulate the economy, if necessary. At 1%, he can’t go far without hitting bone.

Raising the interest rate wouldn’t be painless: indebted households would struggle to keep up with their bills, and bankruptcies could very well rise. But that pain today would arguably be less severe than if rates go up years from now, when households have piled on even more debt. Expect howls of protest from manufacturers, too. Raising rates while the Federal Reserve in the U.S. keeps printing money will send the Canadian dollar higher, increasing the price of exports and hurting the profitability of manufacturers. However, this isn’t a legitimate reason to keep rates low. The Bank of Canada’s mandate is to target inflation—not the exchange rate. Carney reiterated this point in a speech just last month. “The bank does not intervene [with the dollar], except in exceptional circumstances, such as if there were signs of a serious near-term market breakdown or if extreme currency movements seriously threatened [the economy],” he said. Furthermore, if Carney raises rates slowly and signals to markets where he’s heading, the dollar shouldn’t take off. Thorsten Koeppl at Queen’s University doesn’t expect a 0.25% bump in the overnight rate to move the dollar by much more than one cent. “It’s not going to wreck anything,” he says.

Perhaps the biggest risk if Carney doesn’t act soon enough is inflation. It looks remote today, but the conditions are right—not only in Canada, but around the world, as central banks pump money into the financial system. “Inflation has a habit of sneaking up. And when it does, it sneaks up very quickly,” says Parkin. He predicts inflation approaching double-digits by 2020, given the unprecedented levels of monetary stimulus from central banks. That would easily devastate retirement savings, send bond prices crashing, and punish retirees yet again. Debt servicing costs would rise for the government, too, sparking a budget problem. The Bank of Canada would have to tame inflation by raising rates aggressively, choking off the flow of credit to consumers and businesses, and potentially sending the economy into a recession. “It’s going to be an almighty storm,” Parkin says. He recognizes his view makes him an outlier. But even a more subdued hawk such as Koeppl says it’s prudent for Carney to start tightening within the next six months to get ahead of inflation. “It’s very hard to bring inflation expectations down again,” he says.

Should Parkin’s nightmare scenario pan out, the blame would lie not so much with Carney but with Ben Bernanke at the Federal Reserve, who is bent on using the full force of monetary policy to boost the U.S. economy, consequences be damned. But Carney doesn’t have to jump off the bridge just because Bernanke has. “He should begin by leading the world, and say, ‘Look, the time is now for beginning to return to normal,’” Parkin says. “If the Americans won’t go along—and they probably won’t—we should still do it.” He doubts Carney will act soon enough. “The urgent fear of the present outweighs the calamity of the future,” he says.

The choice is not an easy one, and neither course of action is without risk. But that’s what the governor of the Bank of Canada is there for: to make tough calls with high stakes. A central banker paralyzed by fear of making the wrong choice is a serious problem. The rest of us have no choice, however. In Mark Carney, we trust. But for how long?