Carney debunks cheap money strategy

By Vikram Barhat | December 14, 2010 | Last updated on December 14, 2010
3 min read

It was a gloomy economic outlook gift wrapped in the promise of a low interest environment. The temptingly titled Live with Low for Long speech by Mark Carney, governor, Bank of Canada, was anything but the Christmas gift it sounded like.

Speaking at the Economic Club of Canada in Toronto, Carney said interest rates at low levels for a long period of time could potentially distort behaviour in the public, financial, corporate and household sectors.

“Experince suggests that prolonged period of unusually low rates can cloud assessment of financial risks, induce a search for yield, and delay balance sheet adjustments.”

“In a world awash with debt, repairing the balance sheets of banks, households and countries will take years,” said Carney explaining the factors that have led to a low interest rate environment in major advanced economies. “For the crisis economies, the easy bit of the recovery is now finished.”

Calling for the need for rapid consolidation, he said fiscal stimulus is turning into fiscal drag for some countries. “Temporary factors supporting growth in 2010 — such as the turn in the inventory cycle and the release of pent-up demand — have largely run their course.”

Carney cautioned that low rates today do not necessarily mean low rates tomorrow. “Canadian monetary policy will continue to be set for overall Canadian conditions and guided by our two percent inflation target.”

“Cheap money,” he said, “is not a long-term strategy.” He urged Canadian institutions not to get lulled into a false sense of security due to low current rates.

The message was that market participants should resist complacency and constantly reassess risks. “Risk reversals when they happen can be fierce: the greater the complacency, the more brutal the reckoning.”

Historically, low policy rates create their own risks. “Aside from monetary policy, Canadian authorities will need to remain as vigilant as they have been in the past to the possibility of financial imbalances developing in an environment of still-low interest rates and relative price stability.”

In an environment of recession involving financial crisis, very low monetary policy rates in the advanced economies could last awhile, he said with reference to the recent extensions of unconventional monetary policies in the U.S., Japan and Europe.

Comparing recovery patterns in Canada and U.S. Carney said the two economies have performed very differently. He validated divergence of the monetary policies of the two countries by showing how they responded to extraordinary monetary and fiscal stimulus in the wake of the crisis.

• Canadian output has now surpassed its pre-crisis peak (a situation unique in the G-7). • Canadian final domestic demand has grown by 5.7% since the trough of the crisis—more than twice the rate (2.6%) in the United States. • The Canadian economy recovered all of the jobs lost in the recession and added a further 23,700; the U.S. economy has recovered only one-tenth of jobs lost, while over 40% of unemployed workers have now been out of work for more than half a year. • Household credit has grown by about 7% in Canada since the trough in GDP; in the United States, it has fallen by 3.5%. • The most recent rates of core inflation were 1.8% in Canada versus 0.6% in the United States.

The news, however, is far from celebratory. Much remains to be done in Canada. “The weak links in the Canadian economy have been poor productivity growth and declining export competitiveness,” he said. “A rotation of demand from household expenditures to business investment and net exports will be important to a sustained Canadian expansion.”

These are extraordinary times, he said. Canada entered this crisis extremely well-positioned and has managed well through the turmoil. “But the challenges we face have only just begun.”

Vikram Barhat