07/17/2011 11:06 EDT | Updated 09/16/2011 05:12 EDT

Europe Credit Crisis And U.S. Debt Gridlock Places Bank Of Canada In Conundrum

Flickr: colros

THE CANADIAN PRESS -- OTTAWA - The Bank of Canada faces a conundrum.

With the Canadian economy on track, it is not a question of whether the central bank should raise rates, but rather when the increase will come.

But faced with a growing credit crisis in Europe and fiscal gridlock in the United States, Bank of Canada governor Mark Carney has repeatedly raised concerns about the potential fallout on the Canadian economy.

"The proverbial rock is an economy that is expected to grow just fast enough to absorb the limited amounted of slack that's still tamping inflation," BMO economist Sal Guatieri wrote in a report.

"The hard place that Carney is caught between is the growing risk that Canada's economy will underperform if U.S. demand remains weak and/or Europe's credit crisis erupts and spews lava across global financial markets."

The central bank is widely expected to keep its overnight rate target at one per cent when it makes its rate announcement Tuesday, followed by its Monetary Policy Report on Wednesday.

The latter is expected to help clarify where the central bank sees the economy headed and just how concerned it is about the international chaos as it heads into the fall and its next rate announcement in September.

"In our view, a gentle tap on the brakes later this year, once the U.S. economy has perked up and Europe's crisis has calmed down, likely strikes the right balance," Guatieri wrote.

The latest rate announcement comes as U.S. lawmakers fight over increasing the government's debt limit. A failure to increase the cap by the Aug. 2 deadline could send shockwaves through the financial markets if the U.S. defaults on its debt.

Glen Hodgson, chief economist at the Conference Board of Canada, predicted the Bank of Canada would stay on the sidelines for now and look to increase rates in the fall.

"Increasing rates now with the U.S. not having a clear decision on the debt ceiling is inviting more instability and risk into Canada," he said.

Hodgson said Carney is right to also be worried about the affect of the Greek debt crisis on the banking sector.

The central bank's overnight target rate affects prime lending rates at the big banks and in turn the rates on variable rate mortgages and lines of credit.

An increase in the prime lending rate will push up the cost of borrowing for those using a line or credit and up mortgage payments for those with variable mortgages.

Speaking to a Senate committee last month, Carney warned that the second quarter in Canada could see growth drop all the way to the one per cent range, from 3.9 per cent in the first three months.

The bank last hiked interest rates in September 2010.

The C.D. Howe Institute's monetary policy council recommended last week central bank raise its target for the overnight interest rate by a quarter point to 1.25 per cent.

However, the recommendation by the mix of private sector economists and academics was not unanimous with five members of the panel recommending the increase and four others suggesting no change.