Why Rates in Canada Are Staying Put for the Time Being

As widely expected, the Bank of Canada left the country’s key interest rates the same at 4.5%. The rates did not go up because the credit crunch is still very much a reality and because of the soaring Canadian dollar that is squeezing all the excess juice out of the economy. On the other hand, our economy is not nearly in as bad a shape as the U.S. economy, which is why Canada’s central bank did not decrease interest rates either.

Usually, in such trepid markets, central bankers are careful what they say, since a clearly expressed opinion can sometimes send the markets in overdrive in either direction, depending on the circumstances. However, I like our Bank of Canada Governor Dodge, who never misses an opportunity to clearly say what is on his mind. This week, he said that although our economy is operating at full capacity and then some at the moment, there are signs things are not likely to stay that way for too long.

Why? For starters, the output growth numbers coming from the U.S. are disheartening. This is bound to have adverse impact on the Canadian economy in 2008, when the Bank of Canada expects a weaker growth rate of 2.3% on an annualized basis.

Furthermore, Canada’s current core inflation is stubbornly stuck at about two percent, but the bank expects it to retreat to the target level, which is also why interest rates did not go up this week.

Finally, the Canadian dollar has soared way past any prediction point offered either by the central bank or by currency analysts. Governor Dodge warned again that while our strong dollar has its advantages, it is expected to have adverse impact on the economy’s overall output growth and inflation, everything else being equal.

So, when correlating these three factors against each other — credit crunch, strong Canadian dollar and inflation — their joint effects have already created an increase in effective interest rates of an estimated 25 basis points. Hence, Governor Dodge concluded there was no need for fiscal policy interventions at this point, which is why interest rates have stayed put.

Where is Canada’s economy to go from here? It doesn’t take a rocket scientist to conclude that things have drastically changed over the summer. In July, the Bank of Canada increased interest rates for the first time in over a year, and the sentiment was that more rate hikes were in the cards.

However, forecasts that resulted in the July interest-rate hike have since changed drastically. While Canada’s output growth rate for 2007 is expected to meet the forecast of 2.6%, numbers for 2008 have been revised downward, from an early summer estimate of 2.6% to the current one of 2.3%.

I expect interest rates will continue to hover at 4.5% for as long as there is fuel in the Canadian economy’s jets. However, if our dollar, tight credit conditions and inflation continue applying pressure as they have so far, it stands to reason that the country’s overall economic growth will slow down, potentially prompting interest-rate cuts to jumpstart it again.