At the 2010 annual interest rate forecast lunch on 12 January 2010, the two panellists agreed that rates would be rising later in the year, while providing differing reasons for the expected increases.

Key hurdles to further growth

Peter Hall
Vice president and chief economist
Export Development Corporation Canada (EDC)

According to Peter Hall, there are several hurdles to overcome along the path to further economic growth. Commodities remain overpriced, and Hall expects them to deflate by the middle of 2010. Comparing data year over year, he stated that inflation, another hurdle, is set to accelerate in the next few months. However, given the current low level of inflation, he does not see a need for rate hikes to fight this “base effect.”

Hall took us back through history to show how bubbles have occurred at the end of each market cycle. This time, the growth phase has lasted twice as long as in many other cycles, and as such, we have ended up with a “super bubble.” Trade globalization and exceptional strength in global economic growth were two of the factors contributing to the longevity of this current growth phase. Global trade has grown from 40 percent of global GDP in 1992 to close to 65 percent in 2007, resulting in increased interdependencies between the world’s economies. In turn, the consumption excesses of the developed world have translated into excess production in the emerging markets.

Hall also cautioned policy makers against unwinding fiscal stimuli in response to this base-effect inflationary pressure.

“Spending $568 billion in stimulus money increases your GDP in the first few quarters, it does not impact it for the next few quarters even though spending continues, but then negatively impacts GDP as the program winds down.”

Finally, Hall also reminded us of additional global financial system stresses that need to be worked out. For example, as unemployment rises, credit defaults will rise, although Hall expects to see an improvement to the default risk toward year end, given that we will then be past the top of the default cycle. In addition, based on IMF studies, toxic assets have not yet been completely removed from the system.

Patience is a virtue, but…

Avery Shenfeld
Managing director and chief economist
CIBC World Markets

“Patience is a virtue in finding the right time to raise rates, but history has shown that the Bank of Canada has hiked rates prematurely in the past, only to have to reverse course when the economy disappointed.”
– Avery Shenfeld

Rates to rise prematurely: Chart 1 shows how the Bank of Canada has hiked rates prematurely in the past, and Shenfeld expects the Bank will once again hike rates too soon. He expects rates to rise by 75 basis points by the end of 2010, with the Bank continuing to tighten into 2011. This will make the second half of 2010 ugly for bonds, while equities should do well in the next 8 to 10 months. Forward P/Es are at historical norms–meaning they’re neither cheap nor expensive.

Real estate to dampen growth: Even though effective borrowing rates have come down substantially compared to 2002, Canadian households’ debt servicing burden has remained high. When rates rise, the costs of servicing this debt will also rise, putting a damper on Canadian households’ expenditures and negatively affecting Canadian GDP.

Canadian unemployment to rise: Given the expectation that the U.S. economy will slow in the second half of 2010, we can expect a Canadian slowdown accompanied by higher unemployment starting in the third quarter of 2010. Manufacturing and resources that are likely to benefit from an anticipated rebound in demand in the first half of 2010 (due to the U.S. stimulus and inventory factors) will feel the pressure of falling demand and the overvalued Canadian dollar. Based on CIBC’s analysis, the Canadian dollar is overvalued by roughly 10 cents relative to commodity prices. As such, the Canadian dollar will continue to be a drag on exports, resulting in a further slowdown in GDP growth and higher unemployment.

U.S. inflation and interest rates will remain flat: Shenfeld believes that the housing glut will contain core inflation in the U.S. With more vacancies, rents will go down, keeping inflation under control. As a result, he believes that the U.S. will not increase rates until at least 2011.

Shenfeld expects growth in the U.S. to be sluggish for the second half of 2010. The effect of fiscal stimuli will fade away by the second half of 2010, while the contribution of inventory rebuilding to economic growth will also be lighter later in 2010 than in the first half of the year.

Consumer spending is not expected to lead the U.S out of recession, as the savings rate of U.S. households is expected to keep growing. In addition, bankers are unlikely to provide credit to consumers as they did before.