A case for Mark Carney to start raising rates immediately

Considering how many times Mark Carney has pointed to risks from abroad in explaining why he has kept interest rates on hold since last fall, it's little wonder that almost everyone who watches the Bank of Canada expects another no-change decision this Tuesday.

To most observers, signs that the U.S. recovery is deteriorating and mounting evidence that the European debt crisis will keep getting worse before it gets better suggest Mr. Carney is right to be more fearful of ``downside" risks to growth and inflation than of ``upside" risks, even as the Canadian rebound hums along.

Inflation has accelerated in recent months, but not so much that expectations for future prices are way out of whack. The central bank's recent survey of businesses across the country showed that even as executives brace for continually rising input costs, many are hesitant to raise prices, since consumers are preoccupied with debt and juggling expensive gas and food against discretionary items.

Still, one of the nation's pre-eminent inflation ``hawks" argues Mr. Carney's ability to maintain super-low borrowing costs without unleashing rapid, difficult-to-contain inflation is on borrowed time. Michael Parkin, economics professor emeritus at the University of Western Ontario, says Mr. Carney should raise rates by 25 basis points at his July 19 decision - and at every decision thereafter until next May. Why? To bring monetary policy to a so-called neutral level by mid-2012, when the central bank projects that the remaining slack in the economy will be gone.

Staying on hold for longer, Prof. Parkin argues, could cause inflation expectations to come loose, which would become self-fulfilling and send price gains spinning out of control. To Prof. Parkin, all policy-making errors are not equal: Rate hikes that turn out to be too aggressive for the economy can be reversed easily, even if Mr. Carney might find doing so a bit embarrassing; on the other hand, a grip on inflation can be extremely tough to regain once it's lost.

``There is an important asymmetry in the cost of errors, and the risks need to be unbalanced away from rising inflation," Mr. Parkin writes in a report for the Toronto-based C.D. Howe Institute. ``If inflation breaks loose of its anchor and moves seriously above [the central bank's 2-per-cent target] the situation can be addressed only with seriously above-normal interest rates. That is a risk to be avoided.''

Indeed. That risk, he argues, could cause a ``policy-induced recession," which would then help bring inflation back down, but in the worst possible way.

Prof. Parkin's argument is timely because the Bank of Canada has been concerned that too many households are ill-prepared for higher rates, having used favourable lending conditions to pile up massive amounts of debt. In a worst-case (though still unlikely) scenario, a wave of defaults could leave Canadian banks writing down loans at the very same time the global financial system comes under increased stress because of Europe's ongoing debt woes.

Either way, a scramble to put a lid back on inflation through steep, aggressive rate hikes could devastate many manufacturers, as they struggle in the face of softening demand from overseas.

Among other variables behind his warnings, Prof. Parkin points to the fact the U.S. Federal Reserve Board is still many months away from tighter policy, meaning the U.S. dollar will continue to weaken. For much of this year, better prospects for Canada, high commodity prices and a weak greenback have been some of the main drivers of the sky-high Canadian currency, in turn helping to restrain inflation by making imports cheaper.

But according to Prof. Parkin, if markets believe Mr. Carney will stay on the sidelines for a long, indefinite period like the Fed, the loonie could drop, which would help exporters but would also remove a crucial brake on inflation.

``Balanced upside and downside risks call for a policy response that moves the balance away from the upside," Prof. Parkin argues. ``Unanchored inflation expectations can lead quickly to above-target, even to double-digit, inflation.''

All of which makes some sense.

However, it makes more sense if you believe, as Prof. Parkin does, that Mr. Carney will lose control of inflation if he fails to raise his benchmark rate to ``neutral" by mid-2012, and that neutral means at least 3 per cent (i.e. eight consecutive 25-basis-point increases, starting July 19). A growing number of economists, though - including Mr. Carney - have mused in recent weeks that the sweet spot could be much lower than in the past, precisely because of the downside risks that Prof. Parkin suggests are less important.