07/05/2011 07:48 EDT | Updated 09/04/2011 05:12 EDT

Bank of Canada Makes the Case for Higher Interest Rates

Canada's inflation rate rose by an annualized 3.7 per cent in May. This exceeds the Bank of Canada's 2 per cent annual inflation target by a wide margin and means an interest rate hike could be back on the Bank's agenda. A closer look at the numbers, however, suggests the need to move interest rates higher may not be as urgent as it appears.

The main cause for the surge in year-over-year inflation is due largely to the price of oil. In May 2010, crude oil was trading around $75 a barrel -- one year later, the price of oil had jumped by half as much again to $112. The resulting jump in gasoline and transport costs contributed to across-the-board price increases for Canadian consumers and prices remain elevated.

At the same time, Canada's "core" inflation rate which eliminates energy and food prices places inflation at a more manageable 1.8 per cent. This is within the Bank of Canada's target, but it is at the point where the Bank could be expected to take action to ensure inflation remains under control. So with that in mind, should we be preparing for the Bank of Canada to raise interest rates at its next interest rate announcement scheduled for July 19?

Is a Rate Hike Necessary Right Now?

Slowing growth, plunging consumer confidence, and stagnant job creation are all signs that the U.S. economy is faltering and with Canada's economy so closely connected to the U.S., any slowdown south of the border will certainly be felt in Canada. More than 70 per cent of Canada's exports are destined for the U.S. market and as American consumers circle the wagons and take stock of their expenditures, Canadian manufactures face a potential decline in sales.

Just as Newton's Third Law states that for every action there is an equal and opposite reaction, an action performed in the marketplace is not without consequence. In the case of hiking interest rates, the currency typically receives a boost as investors seek to maximize their exposure to currencies that best balance potential yields with safety of funds. For a country like Canada that derives much of its wealth from the sale of exports, a strengthening currency often has a negative impact on export sales as it makes Canadian goods more expensive for foreign buyers.

During the second half of the 1990s and early 2000s Canadian exporters benefited from a Canadian dollar valued at between 62 and 75 cents to the American dollar. Today, the Canadian dollar is above parity with its U.S. counterpart and no longer holds a tremendous exchange rate advantage. With the U.S. economy already losing momentum, a weaker U.S. dollar vis-à-vis the loonie could make it even more difficult for Canadian exporters to sell to American consumers.

Bank of Canada Governor Mark Carney continues to spread the message that Canadian interest rates must be taken higher -- he just hasn't been very clear on the timing. This is in stark contrast to his counterparts at the European Central Bank and the U.S. Federal Reserve. In Europe, odds are heavily titled towards a rate increase on recent comments by ECB President Jean-Claude Trichet. In the U.S. on the other hand, it appears unlikely we will see a rate hike in the near-term based on Fed Chairman Ben Bernanke's continued pledge to keep rates low for an "extended period."

Currently, the market is pricing a Bank of Canada interest rate increase in the final quarter of the year -- likely as part of the Bank's October rate announcement. By then we will have a better understanding of the state of the current slowdown in the U.S. and there should also be greater clarity regarding the European debt crisis.