July 28, 2008
Economy at a Glance - July 29, 2008
Accept it – the bias for interest rates is upward
On July 15, 2008, the Bank of Canada left its key policy-setting interest rate, the target overnight rate, unchanged at 3.00%. In its accompanying statement, there was an acknowledgement of weakening economic growth, now expected to be only 1.0% (for real GDP) in 2008 and rising inflation that will top out at 4.0% by early 2009. Furthermore, the “hawks” those who want to raise interest rates among the Bank’s decision-makers are gaining the ascendancy.
A similar upward bias for interest rates exists in the United States. Canada’s concerns about inflation rest on only a 2.2% current year-over-year increase in the general price level. In the U.S., the Consumer Price Index (CPI) has been increasing at a 4.0% or higher rate for the past seven months.
At this time, the United States has one of the lowest interest rates in the world. The federal funds rate at 2.00% compares with the Eurozone’s key rate of 4.25%, the United Kingdom’s at 5.00% and Australia’s at 7.25%. Even Switzerland has a higher interest rate (2.75%), despite running a large current account surplus. By way of contrast, the U.S. foreign trade deficit continues to be massive, ranging between $700 and $750 billion for almost two years.
The U.S. low interest rate policy is adding to inflationary expectations through the mechanisms of commodity and import prices. The prices of oil and some other key commodities have been rising as a hedge against U.S. dollar declines. Furthermore, this removes a declining U.S. dollar as a policy option. On past evidence, such action, whether taken deliberately or not, would only act to drive up oil prices more.
The latest financial market problems in connection with Fannie Mae and Freddie Mac, and the loss of confidence in Pasadena-based IndyMac, have peeled back another layer of woes. Regulators are planning to expand available lines of credit and to possibly take equity positions in the two large mortgage entities. However, the uncertainty and consequent tendency towards risk aversion can only apply more upward pressure on available interest rates, if not nominal ones.
The world’s other lynchpin economy, China, is also caught in a dilemma. While China continues to experience explosive real GDP growth of 8% to 10%, its inflation rate has risen to about 8%. Action will be needed to address this problem. Recognition of this fact is part of the reason for the nearly 50% decline in value of Shanghai’s stock market index since the start of this year.
While the current situation looks bleak, there is actually some hope in the way that developments are unfolding. The worsening worldwide prospects for interest rates and growth are forcing a reassessment of the demand outlook for oil. This should lead to at least a temporary easing in the price. It has been high-priced oil and gasoline, added to the forced savings of the credit crunch and the U.S. housing collapse, that have stood in the way of consumers rescuing the economy.
For more articles by Alex Carrick on the Canadian and U.S. economies, visit his blog and Market Insights.
Key U.S. and Canadian Policy-setting Interest Rates
Data sources: Bank of Canada and U.S. Federal Reserve Board.
Chart: Reed Construction Data - CanaData.
