Economy Lab

Mark Carney's conundrum: To raise or not to raise

Special to The Globe and Mail

Bank of Canada Governor Mark Carney speaks at a Vancouver Board of Trade luncheon on Wednesday. (DARRYL DYCK/Darryl Dyck for The Globe and Mail)

Before looking at the speech given by Bank of Canada Governor Mark Carney in Vancouver on Wednesday, it's probably a good idea to first reread the speech he gave a couple of weeks ago in Ottawa. As noted here, Mr. Carney then expressed concern about the inflows of capital into Canada. In the past, these inflows of foreign savings have generally been beneficial, but there's always the risk that they could fuel asset price bubbles.

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The Bank of Canada clearly wants to avoid making the mistakes that the Federal Reserve made in the last decade. It also knows that higher interest rates will likely attract even more foreign capital. Hindsight being what it is, the May 16 speech could be viewed as making the argument against increasing interest rates on May 31.

Wednesday's speech appears to be making the opposite case. Using low interest rates to stimulate activity in the housing sector is of course a conventional tactic for a central bank to apply, and Canada had the good fortune to be in a situation where it could be used to good effect. Residential construction investment was a crucial contributor to the early stages of the recovery, although its role has been much less important in the last four quarters. (See here for more detail on the sources of the recession and recovery.)

But interest rates that remain too low for too long cause problems of their own: if loans continue to be cheap, people will continue to take out more of them. Although debt isn't a bad thing in itself, higher debt ratios make households more vulnerable to even small changes in asset prices. And as recent experience in the United States shows, it can take many, many years to recover from a balance sheet recession. This too is a mistake that the Bank of Canada would like to avoid.

Mr. Carney knows that the only way to slow the accumulation of consumer debt is to raise interest rates, and he wants people to make their long-term spending plans accordingly. Wednesday's speech can perhaps best be viewed as a digression on Stein's Law: "If something cannot go on forever, it will stop."

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