Amid a global economic storm, Carney faces growing dilemma

The next few months could come to define Mark Carney's inflation-fighting legacy.

At every policy decision since last September, when the Bank of Canada Governor raised his benchmark interest rate to 1 per cent, he has judged that the uncertainties dotting the global landscape made it too risky to impose higher borrowing costs or the even stronger currency that would likely come with them.

Mr. Carney is widely expected to take the same approach Tuesday, as the U.S. economy buckles under the weight of persistently high unemployment, a political stalemate that has brought Washington to the brink of defaulting on its debt, and as the European debt crisis threatens to engulf the global financial system.

After Tuesday, though, he faces an increasingly delicate dilemma.

Risks from abroad are arguably more acute, and less predictable, than at any time since the recession. But Canada's recovery is still humming and, by some measures, inflationary pressure is creeping up. As a result, when Mr. Carney releases his latest economic forecast on Wednesday, a day after the rate decision, markets will be on alert for clues about how he intends to straddle those divergent forces.

What it may come down to for Mr. Carney, economists say, is a more forceful reiteration that he is equally mindful of both sides of the ledger, and that he stands ready to act to contain inflation as soon as the international scene settles down. In other words, Mr. Carney might tweak language from his May 31 decision - when he said "some" of the stimulus in the system would be "eventually withdrawn" as the rebound gains strength - to suggest that "eventually" isn't necessarily as far away as some might think.

Doing that, the argument goes, would quash any doubt in markets or among businesses and consumers about whether Mr. Carney will move to stem inflation if and when it threatens to spin out of control, regardless of other factors. That, in and of itself, would keep expectations for price gains firmly anchored, thus serving to help contain inflation.

"To try to make sure that inflationary expectations are under control, you can start tightening policy, or you can indicate that at some future point those pressures may need to be addressed in the hope that that demonstrates a commitment to keeping inflation low," said Paul Ferley, assistant chief economist at Royal Bank of Canada. "The Bank of Canada has a pretty good track record, and I think it helps them out in situations like this."

Mr. Carney has said his monetary policy might need to remain "stimulative" for longer than anticipated in order to buffer the domestic rebound against headwinds like the strong loonie, which is making life harder for many exporters just as demand around the world has either started to, or is poised to, soften. And some of the most recent economic data from Statistics Canada, such as last Friday's disappointing report on factory sales in May, suggest the damage to North American supply chains from the Japanese earthquake may have been deeper and longer-lasting than initially thought.

Still, his central mandate is to keep inflation advancing at an annual pace of about 2 per cent, and there are signs that his ability to stay on hold without losing his grip on price gains is approaching a limit.

Even after stripping out volatile items such as energy and food, annual inflation reached 1.8 per cent in May and looks likely to hit 2 per cent sooner than Mr. Carney was expecting. His own surveys of businesses across the country suggest the spare capacity in the economy is vanishing, and fast. In the most recent poll, released July 11, more than half of the firms - the most since 2007 - said they would have at least some difficulty meeting a surprise jump in demand. That explains why more than half also said they'll be ramping up hiring.

Yet, wage growth is tepid, and many companies are still skittish about passing higher input costs - from the commodities they use to produce their goods, for example - on to customers, suggesting Mr. Carney has more time to gauge foreign developments. Add in the fact the U.S. Federal Reserve Board is nowhere near raising its main interest rate, meaning any hike by Mr. Carney could send the loonie surging.

The central bank has said it expects overall inflation and the core rate will "converge" at 2 per cent midway through next year.

All told, it's not hard to see why some economists question whether Mr. Carney will, or should, move at all before next year, though some believe he will hike as early as September.

For others, like the "hawks" who make up a slim majority of votes on the C.D. Howe Institute's shadow council on monetary policy, the still-very-low interest rate doesn't mesh with the central bank's forecast for the economy to reach its potential growth rate - the pace of expansion at which anything faster would trigger rapid inflation - by mid-2012.

Unless the trouble lapping at Canada's shores has caused Mr. Carney to stretch that timeline further, a distinct possibility considering the mind-boggling challenges gripping Canada's No. 1 export market, they say he should be tightening now. The alternative, they argue, could be a sharper, faster climb in borrowing costs than Canadians are used to.

The pace of tightening is important, given Mr. Carney's worries that many households will have big problems carrying the debt they've piled up once rates rise.

The key question for Mr. Carney is whether he believes it would be more costly to move too early than it would to wait too long.

"If the sovereign credit issue on both sides of the Atlantic flares up, it will have a meaningful impact on the credit creation process in Canada, period," said Michael Gregory, a senior economist at BMO Nesbitt Burns Inc. "My sense is perhaps the risk of doing something wrong amid that carries slightly more negative consequences than that not happening and the bank being a little behind the curve. The bank has got a tremendous amount of credibility, so I suspect they're going to use a little of that credibility that they've built up."