Danger of runaway inflation means rates could rise sooner: Don Pittis

It's surprising how much central bankers don't know. Not because they are bad central bankers, but because there are things they just can't know.

Bank of Canada governor Stephen Polozsays he won't have to rein in the economy until 2016. The Organization for Economic Co-operation and Development begs to differ, saying we should expect interest rises as soon as this spring.

But there is another reason why not onlyPoloz, but alsoU.S. central banker Janet Yellen may be forced to raise rates much sooner than even they expected just a few months ago.

That is the huge lagbetween when central banks decide to increaserates and when those increases actually act to bring inflation under control.

That is one of the main jobs of central bankers. When there is lots of unemployment and lots of unused industrial capacity, central bankskeep interest rates low to encourage businesses to borrow and invest. But in the growth stage of an economy, that excess capacity gets used up.

Suddenly you reach a point where there is too much money chasinglimited resources. According to economic theory, that is when inflation happens. And to prevent that, the centralbankers must raise rates.

In the past,Poloz has saidCanada won't reach capacity until late 2016. For now, he is pleased to let the economy grow and give exporters a chance to find new markets. According to those who parse his careful statements, that means Poloz won't begin to raise rates until the end of 2015.

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Polozcan't know the future any more than anyone else, but it is his job to read the tea leaves of the economy and make an educated guess. The trouble is, theeconomic signals he reads are constantly changing.

Higher than expected

Yesterday, besides theOECDreport,the U.S. Commerce Department had its own surprise. It revealed that U.S. economic growth, upon which Canadian growth depends,was sharply higher than it had estimated just a month ago, up 3.9 per cent.

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Last week, Statistics Canada also had asurprise. Despite a sharp fall in the price of oil,Canadian inflation came inat a startling2.4 per cent, well above the Bank of Canada's target rate of two per cent.

As BMO economist Doug Porter said, that made Canadian inflation the highest in the industrialized worldapart from Japan.Is that enough to make Poloz change his mind?

Of course, this is just one more thing that central bankers can't besure about. Managingthe interest rate levers of an economy is not a simple tried-and-true formula.It is a lot more like a liveexperiment, where no one really knows what the results will be.

It's not as if central bankers get a lot of practice. The last period when the Bank of Canada faced a battle with serious inflationbeganin the early1970s,when Polozwas still in high school.

But that is why we put academics with doctorates in charge of our central banks.The closest thing they have to an experiment is research on what hashappened decades ago when bankers tried to put the brakes on rising prices.

According to the Bank of England, the effect of raising rates on fighting inflation isdelayed much longer than you might think not just months, but years.

"Official interest rate decisions have their fullest effect on output with a lag ofaround one year," saysthe Bank of England research,"and their fullest effect on inflation with a lag of around two years."

Things can change

There are two big problems when depending on historical research to make present-day decisions.

One is that the forces at work in the 1970smay be completely different from those affecting us now.

Another is that looking back is like reading a road map of what central bankers should have done if only they had known the future. Looking at the actual future is like reading a road mapwith a blank spot.

But increasing signs the economy is heating up are a warning to Poloz and toYellen.

As we saw in 1970s, raising rates too late means central banks must increase them much more sharply to get in front of inflation.

No one expects rates in the teens like we had then, but a rise of even a few percentage points could devastateCanada's property sector.

If that historical research by the Bank of England is correct and there is a two-year lag between interest rate rises and the effect on bringing inflation under control, then waiting too long maybe a bad idea.

Polozgives us his latest update a week from today. Yellen's comes two weeks later. Both would like to delay rate rises until the economy takes off. The only snag is the lag.