Jeremy Torobin – CTV

When the Cana­dian dol­lar topped 95 cents (U.S.) last week, approach­ing a three-week high toward the end of a year that has seen the cur­rency gain 16% against the U.S. dol­lar, it deftly illus­trated the biggest influ­ence on what will be Mark Carney’s most cru­cial deci­sion of 2010.

As econ­o­mists and investors debate with increas­ing vigour about when the Bank of Canada will raise inter­est rates from their cur­rent rock-bottom level, the effect such a move could have on the loonie may mean bor­row­ing costs have to stay where they are well into the recov­ery. The cen­tral bank chief pledged last April to keep his main inter­est rate at the record-low level of 0.25% until at least June, 2010, in order to stim­u­late enough bor­row­ing and spend­ing to solid­ify the economy’s recov­ery. The result­ing ultra-cheap mort­gages spurred a buy­ing spree in hous­ing, and by the fall, Mr. Car­ney was stick-handling around end­less talk – from just about any­where other than the cen­tral bank – of a poten­tial asset bub­ble in res­i­den­tial real estate.

While say­ing the white-hot mar­ket was a result of pent-up demand from Cana­di­ans who had put off pur­chases dur­ing the worst days of the reces­sion, Mr. Car­ney fin­ished the year warn­ing peo­ple to avoid tak­ing on more debt than they would be able to han­dle when inter­est rates go up again, as they inevitably will.

Finance Min­is­ter Jim Fla­herty, albeit indi­rectly, poured some cold water on the notion that Mr. Car­ney would raise bor­row­ing costs before mid-2010 to cool the hous­ing mar­ket; in inter­views last week, Mr. Fla­herty noted he is pre­pared to take steps of his own if nec­es­sary, such as increas­ing the min­i­mum down pay­ment on a home and short­en­ing the max­i­mum length of mortgages.

But even as the cen­tral bank char­ac­ter­ized its con­cerns about Cana­di­ans’ debt loads as a low risk to spread through the finan­cial sys­tem, Mr. Car­ney empha­sized through­out Decem­ber that his com­mit­ment to wait until next June before tight­en­ing mon­e­tary pol­icy was very much con­di­tional on the out­look for the bank’s 2% infla­tion target.

“I’m not wor­ried that we’re in a box, because if things change we would change pol­icy as appro­pri­ate,” Mr. Car­ney told BNN in a year-end tele­vi­sion inter­view that aired Dec. 17. “We have the flex­i­bil­ity to adjust it, either by short­en­ing or length­en­ing [the wait­ing period], if that’s what’s nec­es­sary to achieve our man­date.” And that’s where the loonie comes in.

To keep the hous­ing sec­tor in check, Mr. Car­ney can do lit­tle more than man­age expec­ta­tions for a rate hike that will come even­tu­ally, at a time of his choos­ing. That’s in part because infla­tion is still below the bank’s target.

It’s also because with bor­row­ing costs so low in most of the world’s major economies, rais­ing inter­est rates would make Canada a more attrac­tive place for inter­na­tional investors seek­ing higher yields, which could send the Cana­dian dol­lar soar­ing. That would fur­ther com­pli­cat­ing life for exporters try­ing to regain a foot­ing in global mar­kets that are still smart­ing from the downturn.

“Given the remark­able homo­gene­ity of mon­e­tary pol­icy around the world, you really do risk being that tall poppy and get­ting hit quite hard by the cur­rency,” said Eric Las­celles, a strate­gist at TD Secu­ri­ties in Toronto. Mr. Las­celles pointed to the recent exam­ple of Aus­tralia, another commodity-based econ­omy, where the cur­rency soared against the U.S. dol­lar after that country’s cen­tral bank became the first in the Group of 20 nations to raise inter­est rates in early October.

Last Thurs­day, the Cana­dian dol­lar appre­ci­ated 0.8% in part because investors had started to become more con­vinced the cen­tral bank was merely con­sid­er­ing a rate hike before mid-2010 or, at the very least, before the U.S. Fed­eral Reserve, which many investors see keep­ing rates near zero into 2011. That has helped the loonie out­per­form its major coun­ter­parts this month.

The Bank of Canada, which will update its fore­casts dur­ing the week of Jan. 18, cur­rently main­tains it could even take until the third quar­ter of 2011 for infla­tion to return to 2% and for the econ­omy to be run­ning at full tilt, largely because of the currency’s drag on sales of Cana­dian goods abroad.

Some ana­lysts are paint­ing Mr. Carney’s assess­ment as too cautious.

“Both growth and infla­tion risks lie north of the Bank of Canada’s cur­rent fore­casts,” Yilin Nie and David Cho, strate­gists at Mor­gan Stan­ley in New York, wrote in a recent research report. “We believe the bank will need to hike before its con­di­tional com­mit­ment to keep rates low until June, 2010, and before the Fed. Our fore­casts show the first Bank of Canada rate hike in April, 2010.”

Most Cana­dian econ­o­mists, mean­while, remain in wait-and-see mode.

Michael Gre­gory of BMO Nes­bitt Burns in Toronto wrote in a Dec. 18 note to investors that he sees “increas­ing risk that the pol­icy rate renor­mal­iza­tion process will kick off soon after Canada Day, with a small but not small-enough-to-ignore pos­si­bil­ity that the first action could occur even earlier.”

At the oppo­site extreme, how­ever, are those who believe Mr. Car­ney will wait until late next year, or even later, to tighten – not least because the effect on the cur­rency could be too severe should the Bank of Canada’s bench­mark rate be lower than the Fed’s for more than a few months.

“The Bank of Canada will think very, very hard before rais­ing inter­est rates ahead of the Fed,” said Ben­jamin Tal, a senior econ­o­mist at CIBC World Mar­kets in Toronto, who pre­dicts a slow U.S. recov­ery will keep the Fed on hold and force Mr. Car­ney to wait until the first quar­ter of 2011, when the rate will jump to 1%. “To an extent, not fully but to an extent, mon­e­tary pol­icy in Canada is being highly influ­enced by devel­op­ments in Washington.”

Mr. Las­celles of TD Secu­ri­ties said the Fed won’t aban­don its unprece­dented stim­u­lus until early 2011, with the Bank of Canada there­fore wait­ing until the fourth quar­ter of 2010, even though Canada’s econ­omy is poised to heal more quickly than that of the United States. The bank “can and prob­a­bly should hike rates before the Fed because of stronger fun­da­men­tals, but it really is quite restricted in terms of how much sooner it can go.”

While the image of the cen­tral bank being held cap­tive to the Fed might bring shud­ders to Cana­dian nation­al­ists, Mar­tin Coiteux, an econ­o­mist and pro­fes­sor of inter­na­tional busi­ness at HEC Mon­treal who has tracked mon­e­tary pol­icy in both coun­tries, said the notion is overblown.

First, the effect on the cur­rency of the dif­fer­ence between Cana­dian and U.S. bor­row­ing costs are, his­tor­i­cally, just a few months, he said. And even as Mr. Car­ney wor­ries about hurt­ing exporters any more than they’ve already been hurt, if the domes­tic spend­ing he has stoked in the hous­ing sec­tor catches on enough to raise prices through­out the econ­omy, he’ll have no choice but to raise rates, regard­less of the Fed.

“[The Bank of Canada’s] main objec­tive is to keep infla­tion between 1 and 3% per year, with the tar­get being at 2%,” Mr. Coiteux said. “We might be going up very grad­u­ally toward 2%, but as we move there, in order to keep their cred­i­bil­ity, they’ll have to move, too.”

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