Bank of Canada Keeps It Interesting. Overnight Rate Unchanged.

The BoC is back at it with their scheduled interest rate announcement today.  They left the overnight rate at 1%. As discussed in previous posts this means it lends at 1.25% and pays 0.75% on overnight deposits. I am thinking that this move surprised a lot of people. Many people were expecting that the overnight rate would be raised to 1.25% and continue to move up over the next year or so.

Many banks look to the C.D. Howe Institute’s suggestions for guidance and they routinely give these suggestions a few days before the BoC announcement. This time they “urged” an increase to 1.25% but were obviously ignored.  I should mention that the official suggestion from the C.D. Howe Institute is taken from the median suggestion from 12 members of their monetary policy council. You will see the breakdown of the voting in the link.  So there were members that believed it was better to keep the rate where it is. In all 5 of the 12 suggested keeping the rate at 1%.

The current CPI inflation level is 3.3% and people will claim that since this is above the target band of 2% +/- 1% that the interest rate should have been increased.  We should remember that the main indicator that the BoC monitors is core inflation rather than CPI inflation. I have discussed this in the past but it is worth mentioning again; core inflation is calculated as inflation minus the most volatile goods. Fresh fruit and vegetables and fuel, which fluctuate wildly in price, are excluded. Core inflation is currently 1.6%.  The BoC prediction is that these two levels should converge midway through 2012.

Right now the economy is growing fairly well. In the first quarter it grew at an annual rate of 3.9%, which is actually very good.  So if it continues to grow at this rate then we would need to increase the rate in order to slow inflation, however there are a few things that could go wrong. Right now the U.S. is in the middle of a heated debate over their pending.  They are trying to decide if they should massively cut spending right away for come up with a longer term solution that would not be less bad for the economy.  Since the U.S. buys 75% of what we export, if they stop spending we stop exporting. This could seriously slow our growth.

A second thing to consider, still keeping in mind the scale of the trade we do with the U.S.
is that our dollar is quite strong relative to theirs. If we were to raise our interest rate it could increase demand for our dollar and drive our dollar up even further. Again, this hurts our exports. Now the BoC is not supposed to be concerned with this type of thing directly, it is supposed to focus on price stability but I can’t help thing that this may have been at the back of their minds when making the decision.

So what can we expect?  Well first we will need to see how Japan recovers from their terrible disaster and then we will need to see how the U.S. finally figures out their fiscal woes.  So while a nice growth rate in the economy and high CPI inflation might seem to suggest a rate hike I agree with the decision to keep the rate at its current level. I am sure the BoC feels better knowing I support them.

Please type what you think and why.