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Is Canada a bellwether for G7 policy rates?

Posted on Monday, April 26, 2010 at 02:27PM by Registered CommenterSimon Ward | CommentsPost a Comment

The Bank of Canada last week became the first G7 central bank to signal policy tightening by abandoning its "conditional commitment" to maintain the overnight interest rate target at 0.25% until mid-year. This surprised economists but had been foreshadowed by a recent rise in short-term bond yields – see first chart.

The consensus view is that Canada represents a special case because of its healthier banks and budget finances. Policy-makers in other G7 economies, it is argued, will be slower to tighten because growth will be constrained by restricted credit supply and fiscal tightening.

The differences, in fact, are not so great. Loan officer surveys suggest a similar improvement in credit conditions in Canada and the rest of the G7 – second chart. Canada's fiscal position is better but it is still running a structural deficit of more than 3% of GDP, according to the OECD. Other G7 countries, moreover, are hoping to delay wielding the axe until 2011 or beyond. The Bank of Canada, like other G7 central banks, believes that domestic economic slack is substantial. With core inflation below target and the exchange rate strengthening, policy tightening is arguably less urgent than in the UK, where the Bank of England is losing control of inflationary expectations.
 
This suggests that either other G7 central banks will soon follow the Canadian lead or else the Bank of Canada will be forced to backtrack, perhaps because of a surging currency. A rise last week in US and UK short-term bond yields is consistent with the former scenario – first chart – but a policy shift could be delayed if the Eurozone debt crisis continues to escalate.


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