The Bank of Canada should raise interest rates tomorrow, but it probably won't

The Bank of Canada hasn't changed its target for the overnight rate since May 24, 2006 - seven consecutive decisions to not change the target have followed. But there are several reasons to think that the time has come for this streak to end:

• Core inflation has been steadily drifting up over the past few months, and is now at 2.5%. When that happened in 2002, the Bank responded by increasing interest rates.
• The risk of a slowdown appears to be receding. GDP, the leading indicator and employment are all growing steadily.

The CD Howe Institute's panel has called for the Bank to increase the overnight target by 25 basis points, to 4.50%, but my bet is that the Bank will content itself with a signal for an increase on July 10.  In its April 24 decision, the Bank said

The Bank continues to judge that the risks to its inflation projection are roughly balanced, although there is now a slight tilt to the upside.

The current level of the target for the overnight rate is judged, at this time, to be consistent with achieving the inflation target over the medium term.

Compare this with the warning it provided in July 2005, before its decision to increase interest rates in the following September:

[t]he Bank has held the target for the overnight rate unchanged since October 2004. However, in line with the Bank's outlook, some reduction in the amount of monetary stimulus will be required in the near term to keep aggregate demand and supply in balance and inflation on target.

The Bank has been very careful to telegraph its moves in advance. Inflation isn't out of control yet, so it can afford to take time to shape expectations for its July decision.

Update: As houlie4 kindly notes in the comments, I was right. The target stayed where it was, but

... the Bank judges that there is an increased risk that future inflation will persist above the 2 per cent inflation target and that some increase in the target for the overnight rate may be required in the near term to bring inflation back to the target.

Comments

[houlie4]

well played... (http://www.bankofcanada.ca/en/fixed-dates/2007/rate_290507.html)

[Jim Rootham]

Interest rates are the wrong thing to use as the principle mechanism for controlling inflation. They hit the powerless and marginalized people far too hard to be considered ethically sound.

Corporations that raise prices should face higher rates of income tax.

The upper levels of personal income tax should also increase in times of higher inflation (this is less critical).