Bank of Canada's economic cheer will be painful for some: Don Pittis

This column is part of a series we're calling Debt Nation looking at the state of consumer debt in Canada. Look for more coverage in the coming days, including onmortgages and credit card debt.

The Bank of Canada has sounded a warning that borrowing costs could start rising even faster. And that was after hiking rates yesterday for the fifth time since last summer.

While tacking on an additional quarter of a percentage point to the cost of borrowing yesterday, Bank of Canada governor Stephen Poloz and his deputy CarolynWilkinswere as optimistic as they have been about the state of the economy.

Of course for over-borrowedCanadians a strengthening economy is always a double-edged sword. After years of low rates needed to perk the economy up, clear signs of strength mean rising rates.

And hidden amidst the careful tone and dreary presentation essential to any sober central banker, Polozand Wilkins were almost upbeat.

Bad news is good news

"Higher interest rates arealways difficult when people haven't seen them for a long time," said Wilkins at yesterday's news conference to discuss the bank's latestMonetary Policy Report.

"Butwhen they're coming at a time when the economy is growing and it's a sign we're getting back to a more normal phase, in a lot of senses it's good news."

There are still risks to the economy including the Chinese-American trade war and the possibility that Canadian borrowers could buckle under risingrates, but overall the mood, by central banker standards, was buoyant.

International currency traders noticed one thing in particular that helped drivethe loonie higher. It was the removal of the word "gradual" from the statement on the expected path of interest rate changes.

Despite plenty of back-pedalling by Wilkins and Polozon the subject, seemingly fearful of giving too much away, it seemed clear that the Bank of Canada wanted to prepare markets, and Canadians, for the possibility of more and faster interest rate increases.

While insisting that those faster rate movescould be up or down depending on economic conditions, Polozrevealed that his intentwas to correct the impression in the financial sector whichhe referred to as "the street" that the bank was locked intocreeping rate hikes even if a quicker pace were needed.

"Markets seem to have settled on 'gradual,'meaning we would only move every second meeting," responded Poloz to a reporter's question. "To put it most bluntly, that's what I heard from the street, and we thought, well, we really don't want to reinforce that as a locked-in mechanical expectation."

A statement like that gives the bank an air of unpredictability, keeping traders on their toes,and gives fair warning thatPoloz and Wilkinshave the flexibility to move quickly to block an unexpected increase in prices or wages.

Read more stories in the series:

• How much do we owe, and what are we doing about it?
• Homeowners worried about paying down debt as interest rates go up
• Long-term loans are the fuel powering Canadian car sales

COMING FRIDAY:

• DonPittisexplains why credit card debt canbe a dangerous trap

Exceptional risk

Although the bank is predicting that inflation will continue at a moderate twoper cent, the economy is operating at or near capacity, meaning there could be a sudden surge, not uncommon in the late stage of an economic boom, in the price of labour and otherbusinessessentials.

In the strange language of central bankers such a boom is seen as"an upside risk" that the economy will do even better than they are expecting.

One of the reasons for the bank's current tone of optimism is that the North American trade deal has been settled, a worry in previous outlooks. Despite recent market turmoil, the U.S. economy continues to do well and while it may falter once the fiscal stimulus of taxes and spending run out, Wilkinssays stimulus could launcha long-hoped-for surgein "animal spirits."

"The U.S. economy seems to be exhibiting some animal spirits," said Wilkins. "You get into this virtuous circle where businesses have good demand and they become more confident and they invest more."

Another upside risk in other words, great news for the economy but bad for borrowers would be if China and the United States were able to settle their trade battle in some sort of amicable way.

But until that happens, the Bank of Canada has declared that nowthatNorth American tradehas been settled, thefight between the world's two biggest trading nations remains the biggest downside risk to the global, and to the Canadian, economy.

Also a risk on the down sideis that the bank discovers rising rates are overwhelming so many over-borrowedCanadians that their economic hardship begins to feed back into the wider economy with a steep fall in houseprices or a sharp decline in spending.

Rates to double?

But the bank's research so far has shown that is unlikely. The mortgagestress tests that somereal estate tycoons complain have killed the market mean house prices are no longer rising at absurd rates of 20 per cent a year, said Poloz. That means a slowdown inthe panic of "FOMO, the fear of missing out," that in recent yearshas led new home buyers into bidding wars, he says.

Essentially, the bank says that current low interest rates are still stimulating the economy in a way that is likelyunwarranted now that the economic crisis that began in 2007 is over.

A strong, normal, economy means interest rates must continue to rise until they reach the "neutral rate" the level of interest that neither stimulates nor impedes regular economic activity. The neutral rate is an economic concept, not a hard figure, but the bank estimates Canada's neutral rate could be as high a 3.5 per centdouble current interest rates.

"I get it that it can be difficult for some," conceded Poloz. "But the reality is thatthe economy is running at its capacity and is nolonger needing stimulus.

"And it's our job to prevent the thing from overheatingand creating inflation pressures down the road."

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