BOC Holds Rates at 1.00%… But Until When?

According to the accompanying statement, BOC Governor Mark Carney and his men still see plenty of challenges ahead even though the Canadian economy performed slightly better than expected. Such “elevated risks” include persistent debt concerns in the euro zone and supply shocks from political conflicts in the Middle East.

But when it comes to the Canadian economy itself, they proudly noted that consumption remained strong and that business investment continued to expand. Aside from that, they also pointed out that Canadian exports are doing well, thanks to faster economic activity in the U.S. and stronger demand for commodities.

So if Canada ain’t doing so bad, how come the BOC still refused to hike rates?

When evaluating any economy, we can’t simply place it under a microscope. Sometimes, we have to step back, take a look at the big picture, and observe the international scene as well.

The ongoing turmoil in the Middle East has elevated oil prices to new two-year highs. Not surprisingly, the Loonie, which has a strong correlation with black crack, hit new highs of its own, rising 2% in February.

That being the case, I suppose it was wise for the BOC to hold off on hiking rates. Any signs of hawkishness would probably accelerate the Loonie’s appreciation, which is something the central bank would like to avoid for the sake of its exports.

We also have to keep in mind that Canada‘s largest trading partner, the U.S., is set to end its QE2 program in July. Since these two countries are practically joined at the hip, the expiration of QE2 could have tremendous repercussions on Canada as well. So in hitting the pause button on rate hikes, the BOC is taking the safe route. It’s basically giving the economy more room to secure its footing before QE2 expires.

Inflation-wise, the central bank also had little reason to raise rates. Inflation remained subdued at 0.3% in January, and the Loonie’s strength should help combat inflationary pressures in the near future.

But not all things point to keeping rates at 1.00%. On Wednesday, Canada released a very impressive and surprising GDP report.

According to the report, the Canadian economy expanded at an annualized rate of 3.3% in the last quarter of 2010, above what the market had initially predicted. The robust growth mostly came from continued strength in consumer spending and a surge in exports.

Consumer spending, which comprises majority of Canada’s GDP, increased by 4.9% due to higher demand for durable goods. That’s almost DOUBLE the figure seen the quarter before.

Meanwhile, exports were reported to have risen by a whopping 17.1%, the highest rate of increase in almost seven years. Apparently, improved demand for Canadian goods like industrial materials and energy products was the primary cause of the unexpected jump.

Prior the GDP report, the market had expected the BOC to raise rates come July. But now, the market believes that a rate hike could come as early as May! If exports still climbed despite the strong Loonie, then there’s nothing to stop the BOC from hiking interest rates in the next couple of months, right?

In any case, it seems that the BOC will have to do a very delicate balancing act in the next couple of months – bring monetary policy back to normal levels without negatively affecting economic recovery.

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