OECD urges Canada to raise rates

An influential international body is urging Canada’s central bank to raise interest rates in the fall, and continue doing so through 2013 to cool housing prices and contain inflation.

The Paris-based Organization for Economic Co-operation and Development’s prescription for monetary policy will stoke the already hot debate about whether the Bank of Canada’s interest rate stance is inflating a housing bubble.

Governor Mark Carney and other officials say the days of ultra-cheap money are coming to an end, although they so far have declined to be more specific. The OECD, a high-powered economic research group backed by contributions from its 34 rich country members, offers a scenario: An increase in the benchmark rate of a quarter of a percentage point in the autumn, and similar increases each quarter through to the end of next year, leaving the benchmark overnight target at 2.25 per cent.

That still would be low by historical standards, yet, according to the OECD, likely a big enough increase to cause prospective homeowners to think twice before buying at current inflated prices. However, the OECD’s recommendation comes with a risk.

The Federal Reserve Board has made a conditional pledge to leave U.S. rates extremely low until the end of 2014. Following the OECD’s path could create an unprecedented spread between Canadian and U.S. interest rates, which would put upward pressure on a Canadian dollar that many say already is too strong.

The OECD called on Canada to raise interest rates a year ago and was ignored.

Canada’s household debt has surged to roughly 150 per cent of disposable income, driven mostly by mortgages. For the better part of a year, Mr. Carney has tried to deflate mortgage lending by warning Canadians they were becoming too stretched. But he has resisted raising borrowing costs because the broader economy remained fragile amid a sluggish economic recovery in the United States and financial volatility caused by the European debt crisis.

Europe remains a threat – and even more so than only a few weeks ago, the OECD says. But the U.S. recovery is gaining traction, a boost for Canadian exporters. As a result, the economic slack in Canada left from the recession is fast running out. “At most, there is a modest amount left,” said Peter Jarrett, head of the Canadian division at the OECD, said Monday on a conference call with reporters.

That spare capacity is what has allowed Mr. Carney to keep the benchmark interest rate at an emergency setting, even as the country’s economy replaced the jobs lost during the recession and domestic demand surged.

The central bank’s policy stance has helped the economy absorb repeated shocks over the past couple of years, including the blow to international trade from Japan’s tsunami and financial turmoil stemming from the European debt crisis.

But there also is little doubt that the interest rate policy has contributed to rising debt levels. Finance Minister Jim Flaherty has attempted to take the froth out of the housing market by tightening lending standards for mortgages backed by government insurance. The OECD’s Mr. Jarrett said he doubts further prudential measures would do much to cool lending in Canada’s hottest housing markets, including Toronto, Ottawa and Montreal. “That’s why we call for the removal of more monetary stimulus in the autumn,” he said.

The reason to delay is Europe’s debt crisis. The OECD predicts the gross domestic product of the 17 euro countries will contract 0.1 per cent this year, and the crisis has entered an acute phase because an election in Greece next month could result in that country’s exit from the currency union.

But calamity isn’t the OECD’s base case. It forecasts the combined GDP of its members will rise 1.6 per cent this year and 2.2 per cent in 2013 – not great, but not terrible. The United States, Canada’s largest trading partner, will post growth of 2.4 per cent this year, compared with a previous estimate of about 2 per cent.

Big emerging markets such as China and Indonesia will remain strong because governments in most of those can afford economic stimulus programs if necessary, said OECD chief economist Pier Carlo Padoan.

The OECD predicts Canada’s GDP will grow 2.5 per cent next year, compared to about 2 per cent in 2012. That’s faster than most economists think that Canada’s economy can grow without stoking inflation.

Mr. Jarrett acknowledged that higher interest rates likely would cause the Canadian dollar to rise. But the erosion of Canada’s share of global trade has stopped, suggesting exporters have become more competitive.

“Even if there is some further erosion, we feel strength in domestic demand likely will prove to be adequate to keep the economy growing at something like potential through 2013, rather than continue to move beyond full employment and stoke inflation pressures more substantially,” Mr. Jarrett said.