Inflation vs. Debt Contagion: The BOC’s Dilemma

Last Friday, we had another dose of inflation data from Canada, hinting at the possibility that the Bank of Canada would hike rates on their next interest rate decision meeting. After a 1.4% increase the month before, Canada’s headline consumer price index rose by 1.8% year-on-year in April. With the BOC’s inflation target set at 2.0%, the case for a rate hike come June just became stronger.

Even though the sharp spike in inflation was primarily caused by Canada hosting the Winter Olympics, there is no denying that the underlying trend in the country’s inflation rate is heading higher. Moreover, one of the biggest inflation pressures, the fast rise in gasoline prices (16.3% y/y), is showing no signs of abating. Looking at the CPI alone, one could say that the argument for rate hike come next meeting is high…

The question now that is tickling my funny bone now is: Could the BOC turn their recent hawkish comments into actual hawkish moves? Would BOC Governor Mark Carney and his monetary policy mountaineers actually raise interest rates?

Hold on just a second there! While strong inflation figures do support a rate hike, this doesn’t mean that it’s all set in stone. I do believe that the recent financial crisis has made policy makers more attentive and sensitive not only to developments in the domestic landscape, but to what’s happening around the world as well. As Troy Bolton and the Wildcats sang in High School Musical, “We’re all in this together!”

The reason why there is no consensus on whether there will be an interest rate hike or not is because of ongoing debt problems in Europe. These problems have spurred contagion fears that would act as road bumps on the way to recovery. If these fears continue to rule the market, it could restrict growth as investor confidence and demand take a hit.

Now, who stands to lose if this happens? That’s right – everybody. So while hiking interest rates might be a good idea to curb potential hyperinflation, it might just do more harm than good if the whole world is still having a hard time getting back on its feet.

In this old man’s humble opinion, the BOC might be better off “pulling a Fed” (a catchphrase I coined for taking a cautious wait-and-see stance) and take time to assess whether the Canadian economy is strong enough to weather a possible financial crisis. Now that market conditions are looking less stable, it might not be a good time to execute an aggressive tightening move, which could probably end up erasing Canada’s recent economic progress.

Besides, it could be too early to rejoice and assume that the economic rebound would carry on. Although the latest CPI reports support a rate hike, inflation is expected to moderate in the coming months as global financial uncertainties weigh on domestic demand. Maybe postponing their rate hike for a month or two isn’t such a bad idea. This could buy the BOC enough time to wait for more signs of strength from the Canadian economy or for all the smoke to clear from all this debt drama.

With just a few weeks left before their rate decision in June, the BOC still has enough time to discuss and decide what’s best for the Canadian economy.