The Bank of Canada bumped up short-term interest rates by a quarter point this morning.  The overnight target rate now stands at 3.50%, the prime lending rate now moves to 5.25%. The Bank clearly stated that further rate increases would be required to maintain a balance between overall supply and demand conditions in the economy in order to keep inflation in check over 2006-07. 

The accompanying statement, however, indicates that the Bank has pushed outward in time its expectation that core inflation would rise to 2%.  In the October Monetary Policy Report, the Bank had indicated that this would happen towards the end of 2006, but it is now saying this will happen in the first half of 2007.  This may suggest fewer than previously anticipated future interest rate increases.

Upside risks that point to further rate hikes are fully focused on the Bank's view that the Canadian economy is growing at its potential rate and possibly slightly beyond.  Diversified strength is indicated by a healthy export rebound, strong business investment in machinery and equipment and inventories, yesterday’s retail sales figures that point to a stronger-than-expected consumer sector, and growing evidence that industrial, commercial and office construction markets will fill the void left by gradually retreating housing construction.  The result is that very tight markets for labour and raw materials - particularly in Alberta and British Columbia - are putting upward pressure on wage rates and some input prices and thereby pose the risk of igniting classic cost-push inflation that gets passed onto consumers.

An added rationale for further monetary tightening relates to delicately managing how a massive liquidity overhang on world markets gets unwound.  Liquidity ratios on corporate and household balance sheets remain very high - almost in evidence of classic liquidity hoarding - and how this gets redeployed has implications for the expected inflation picture.

An obvious downside risk to further rate hikes clearly lies in the form of precious little by way of current evidence of building inflation.  To be fair, monetary policy takes upwards of a year to a year-and-a-half to work its full effects upon the economy, so changes today are done with evolving conditions over the next two years in mind.  But, there is by no means any guarantee that cost-push pressures - if sustained - will be passed onto consumers, as opposed to absorbed within still strong profit margins and very high levels of corporate liquidity.  Indeed, the factors that may well mitigate any broadening out of inflationary pressures include permanently changed inflation expectations, a push to expand capacity through investment, the ability of the economy to withstand sizeable rate hikes, globalization not least of which through China’s influences, and enhanced market contestability.

A significant wild card concerns the post-election aftermath.  Here are three things to expect from a market standpoint.  First, most polls were already indicating a conservative minority government, so this has already been largely priced into the Canadian dollar and bond yields.  Second, look for fiscal policy to be significantly stimulative which may put heightened pressure upon the Bank of Canada to neutralize the effects through higher interest rates.  Third, even with stimulative fiscal policy, it is likely that respect for fiscal policy prudence will remain in terms of targeting overall budgetary balance and a steadily declining debt-to-GDP ratio, which are what matter most to financial markets.

Wayne Schmitz
Mortgage Specialist
RBC Royal Bank
Cell: (604) 377-6520
Fax: (604) 733-9219
Email: wayne.schmitz@rbc.com