Why a rate hike could come sooner than expected

There is almost no chance that Bank of Canada Governor Mark Carney will use a decision this Thursday to break what has become the longest stretch without an interest rate hike since the 1950s. But even though higher rates are the last thing struggling provinces like Ontario need, if the global backdrop continues to stabilize Mr. Carney's first step off of the sidelines could come sooner than many think.

Mr. Carney has long pointed to the Canadian dollar's "persistent strength" and "competitiveness challenges" faced by exporters as reasons to keep monetary policy looser for longer. Traditional markets and key sectors are still in recovery mode, and an easier lending climate gives manufacturers a much-needed buffer which could, in theory, minimize the gulf between Central Canada and provinces that are benefiting from booming demand for oil and other commodities.

Still, that doesn't mean Mr. Carney is willing to provide an indefinite cushion for industries and regions that may never regain their past form, especially if inflationary pressures in parts of the country that are doing much better threaten to spread.

In a report last week, CIBC economists Avery Shenfeld and Warren Lovely concluded that while Mr. Carney can use low interest rates as a buffer to buy provinces like Ontario more time to adapt to a loonie poised to stay near or above parity with the U.S. dollar, the province's reduced status in the country's economic order is not likely to be a short-lived phenomenon.

"Expect this underperformance to continue, with average annual real (gross domestic product) growth in Canada's industrial heartland – Ontario and Quebec – likely to trail that seen in Canada's most resource-rich regions by at least 1 per cent over the coming five years," the economists wrote. "Even a sidelined Bank of Canada won't prevent a further hollowing out."

Indeed, a national central bank can only do so much to mitigate problems in one region or industry.

Doug Porter, deputy chief economist at BMO Nesbitt Burns – and the author of another study last week that outlined the effects of the currency's 10-year climb from a low of 62 U.S. cents – noted in an interview that since conditions in Central Canada are likely to be tough no matter what the central bank does, Mr. Carney may have to respond to rising inflationary pressures elsewhere. Already, for instance, labour shortages are pushing up wages in Alberta and Saskatchewan.

"Under current trends, the regional divergences might just widen over the next five years rather than narrow," he said. "If some of those other things start to ease – the improvement we see in Europe continues, the U.S. continues to gain traction – then I don't think the regional divergences are enough to keep the Bank of Canada on hold."

Mr. Porter recalls the height of the oil-sands boom during the years just before the financial crisis hit. At the time, then-Bank of Canada Governor David Dodge often had to remind central Canadian critics of his rate hikes that his job was to set policy for the whole country, and inflation in Alberta was threatening to spread across the country, regardless of the havoc higher rates were wreaking in Ontario.

"We could end up with a very similar issue to what we faced back in 2005-2006, and that is the Bank tightening at a time when Central Canada, or even Eastern Canada, is well below potential and is still weak," he said.

To be sure, the logic of lower-for-longer is compelling. Europe's debt crisis is far from settled. The U.S. rebound, while appearing more secure of late, faces the prospect of high oil prices that could squeeze Americans so much at the gas pump that they're forced to put off spending on other things, like cars assembled at Canadian plants. Plus, no matter who wins the presidential election, the U.S. is in for some brutal fiscal restraint in 2013.

And if the U.S. Federal Reserve sticks with its pledge to keep rates at near-zero until 2014, moving much past 1 per cent could ignite the loonie – already lofty due to energy prices and Canada's relatively new status as a "safe haven" for investors – exacerbating Canada's growing regional divide all the more.

Mr. Carney has argued repeatedly that his "flexible" mandate affords him leeway to take longer than usual to return inflation to his 2-per cent target if the economy is too fragile for rate hikes.

However, he has also stressed that the same flexibility cannot be overused. And in a speech last month on the topic, he also reiterated that he anticipates a "gradual reduction" of monetary stimulus – a statement normally reserved for the bank's formal forecast papers.

"For him to say that in a speech, I thought it was a subtle way of saying, 'You've got to keep us on the table. We're not in the same league the Fed is,' " Mr. Porter said. "If they have another nod to that in [this Thursday's]statement, I think it'll be a pretty strong signal."

For most observers, Mr. Carney is likely on hold until late next year, and possibly into 2014. But some say not to be shocked if he raises rates at least once in the last few months of 2012. Apart from only being able to shield Central Canada's manufacturing base from higher borrowing costs for so long, Mr. Carney also has indicated escalating concern about Canadians' record levels of household debt. So far, the pace of borrowing has slowed, but not by as much as you might expect, considering the parade of warnings over the past two years.

As economists are fond of saying, it is only a matter of time before Mr. Carney concludes that actions speak louder than words.

"There's more probability that the Bank will surprise us with a sooner increase in rates," said Charles St-Arnaud, a Canada analyst at Nomura Securities in New York. "As soon as all the uncertainty is removed, they could shift gears very quickly."