05/15/2013 11:01 EDT | Updated 07/15/2013 05:12 EDT

Canada Interest Rate Hike Needed Now To Avoid Risk Of Crisis: C.D. Howe Institute


OTTAWA - Incoming Bank of Canada governor Stephen Poloz is already getting advice on what to do once he takes charge next month — start hiking interest rates.

A C.D. Howe Institute release authored by economist Paul Masson, a former special adviser to the central bank, argues that after almost five years of super-low interest rates meant to boost growth, it is time to take the economy off its meds.

The paper argues that unlike some other countries that have equally loose or even looser monetary policy, Canada's economy is operating close to capacity. Meanwhile, the side-effects of the monetary stimulus are becoming worse than the disease it is meant to cure.

"Raising interest rates is never popular, but keeping rates low for too long builds in pervasive problems for the economy," he says. "The time has come for the Bank of Canada to start raising interest rates gradually to lessen the continued buildup of financial imbalances."

Low interest rates have contributed to numerous distortions, Masson states, citing underfunded pensions, losses by insurance companies, excessive household debt, high real estate prices and a bias toward high-yielding equities and risk-taking.

And he says low rates are especially hard on savers, particularly older Canadians.

He puts the case of an elderly couple that has worked hard to build a nest egg of $800,000 and has annual living expenses of $36,000. Under a more normal scenario as existed before the 2008-09 crisis, 10-year Government of Canada bonds with a yield of 4.5 per cent would have allowed the family to live off the returns. Currently, with yield at 1.8 per cent, the family would need to dip into the principal or seek higher-return but riskier investments.

Conversely, individuals are lured into borrowing to take advantage of easy money, which has resulted in the two-sided problem of record high household debt — currently 165 per cent of income — and record high house prices.

Bank of Canada governor Mark Carney has warned about staying too low for too long himself, but has nevertheless kept the overnight rate at one per cent since September 2010, a duration of more than two-and-a-half years. Before it had been even lower. He dropped the rate to 0.25 per cent — essentially as low as it can go — in April of 2009.

The approach was part of an international effort by central banks to free up financial markets and boost investment and spending.

In the past year, the bank has maintained a nominal tightening bias, but has not acted on its warnings of coming higher rates. Most economists don't think the bank will start to tighten for real until sometime in 2014, and perhaps as late as 2015.

In his one session with the media last month, Poloz steered clear of questions dealing with monetary policy other than saying he supports the bank's current posture. Some have speculated that given his background in the export sector, he might favour an even looser monetary approach.

Bank of Montreal chief economist Doug Porter says Masson is not the only economist concerned about low interest rates, but he believes there are better reasons for keeping them where they are a while longer.

"I have no doubt if we were an island and we were a completely closed off economy, interest rates would be a lot higher," he said. "But the reality is Canada has limited manoeuvrability given we have a currency that is already overvalued and the rest of the world is easing monetary policy.

"Were the Bank of Canada to start raising interest rates, we'd see the currency skyrocket and absolutely pummel our internationally competitive sectors," he warned.

The other reason for maintaining the current policy, Porter said, is that the housing market and debt accumulation has slowed.

Masson agrees that the dollar is a concern, particularly how it might effect the export-sensitive manufacturing sector, but he notes it has recently dropped below parity. As well, with the U.S. economy recovering and the North American auto industry doing relatively well, Canadian manufacturers would be able to absorb a modestly stronger loonie, he said.

"The answer to this (moderating real estate) objection," he adds, "is that financial cycles are often pervasive and long lasting. Although one might be able to fix some problems, unless the underlying excessively loose monetary policy is corrected, other distortions will emerge — underfunded pensions, the reach for yield, and distortions in equity prices will not be fixed by ad hoc measures."

The next decision date on interest rates for the Bank of Canada is May 29, but the first opportunity for Poloz to direct monetary policy won't happen until July 17.

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