Central bank may still hike rates before summer

Andrew Pyle, On Friday March 4, 2011,
The Bank of Canada has now kept its official interest unchanged at 1 per cent for the fourth meeting.
Those with floating-rate debts will no doubt be relieved; however, economists were looking for a signal from Mr. Carney and crew that improving economic conditions were paving the way for a return to rate hikes sometime soon.
Had this week's policy meeting taken place a few weeks ago, it's likely we would have received that signal. Indeed, most indicators have pointed to stronger-than-expected activity in Canada and the U.S., while emerging economies have maintained a torrid pace of growth.
That would have been before the recent developments in Egypt, Tunisia, Yemen and now Libya. The grassroots uprising against incumbent regimes might be welcome from a democratic ideal perspective, but it has created a rift in energy markets.
Crude awakening
After dipping briefly below $85/barrel in February, the price of crude oil has now broken above $100 for the first time since October 2008, testing $103.40 last week — the 61.8 per cent retracement mark from the July-December 2008 collapse.
A close above this level will increase the odds of a move to $120 (recall that $147.27 was the intraday high from July 2008). And if you thought the recent spike in pump prices was unnerving, gasoline futures have already crossed above the 61.8 per cent retracement level and are trading above three bucks (US) a gallon.
In July 2008, futures broke above $3.70/gallon. Even if prices simply hold near current levels, average pump prices in Canada could easily gravitate towards $1.30/litre. That's not good news for those planning to drive to their March break vacation spots, or for those returning snowbirds.
One might suspect the Bank of Canada would see the boost to inflation, that will come from commodities like oil and gasoline, as something that needs to be worked against through tighter monetary policy, but that's old school.
These commodities, like food (which is also seeing some inflation strain), are essentials and represent a significant share of our non-discretionary spending. Unless incomes rise by the same amount as the cost of these essentials, everything else being different, there will be less to spend on discretionary goods and services. In other words, real consumption growth in Canada could slow.
Not so fast
How much of a slowdown we experience in consumer spending (and let's throw in housing expenditures too), depends greatly on that above-mentioned phrase "all other things being equal."
If employment grows at a decent clip and wages go with it, then the affect on spending will be less pronounced. As of the end of 2010, average weekly earnings in Canada were up 4.5 per cent over the same period a year ago, which was the fourth-best growth rate in earnings since records started in the early 1990s.
To put this in perspective, when crude oil was climbing towards $150 back in the summer of 2008, weekly earnings growth was heading in the opposite direction.
There were other headwinds facing Canada back in 2008, including the cost of borrowing. When oil reached its peak, the 5-year conventional mortgage rate in Canada was above 7 per cent. Today, it sits near 5.5 per cent. The 1-year rate was also close to 7 per cent (yes, we had a very flat yield curve before the walls came tumbling in), compared to 3.5 per cent today.
Now, I'm not suggesting that we're going to stay in interest rate limbo forever, but the Canadian consumer is in better shape to handle higher pump prices today than back two years ago.
How long can they sit on the fence?
What the Bank of Canada has to be careful of here is the oil price shocks emanating from across the pond turn out to be temporary and there is no slowdown in consumption growth. Bank economists are already looking towards 2012 as the likely period where excess capacity in Canada's economy disappears and inflation returns to target (using the core inflation measure).
It is easy, however, to accelerate that trip back to zero excess and just as easy to push the economy into a situation of excess demand.
Coming back to the Bank's decision this week, it may have been surprising to see it lean against speculation of near-term tightening. But, it would be a mistake to assume the Bank can't and won't pull the trigger on rates before the summer.
There are two policy meetings left this half (April and May), so if Mr. Carney and crew wake up and realize there is too much potential inflation risk in leaving rates unchanged, they will need the April meeting to deliver the guidance towards a May rate hike — something economists thought was going to happen this week.
And if energy price shocks don't intensify and the Bank fails to deliver such guidance, don't be surprised if the bond market creates the guidance for them.

http://ca.finance.yahoo.com/news/Central-bank-still-hike-rates-yahoofinanceca-1276928971.html