Blogs & Comment

Where are interest rates headed?

Itsexpected the Bank of Canada will begin raising interest rates in 2010. But how much will they go up? The C.D. Howe Institute recently issued some recommendations in that regard.
The Monetary Policy Council (MPC) of the C.D. Howe Institute is content to let the central bank abide by its commitment to hold the overnight rate at 0.25% until July. Afterward, the median recommendation of the 9-member MPC is for the rate to rise to 0.75% by September and 2% by March of 2011.
Thats much more modest than the C.D. Howe briefreleased two days before by University of Western Ontario economics professor Michael Parkin. After July, he would like to see sharp 50-basis-point increases in the overnight rate at each announcement date until the rate is 3.25% in March of 2011.
The increases the professor calls for are what the Taylor Rule* would prescribe for keeping inflation under control. It currently suggests the overnight rate should be 2% and should rise to 3.25% by March, 2011. The Bank of Canada thus has a lot of catching up to do once its promise of no rate increases expires in July.
Money supply is also growing at double-digit rates currently. As economic growth returns to the long-term trend, such a high rate of monetary expansion will need to be reined in to avoid overshooting the 2% inflation target. A sharp rise in overnight rates is the answer, says Mr. Parkin.
*The Taylor Rule was developed by Professor John Taylor and sets the overnight rate at 2 percent (the neutral real rate) plus the inflation rate, plus a half of the output gap (real GDP minus potential GDP) and half the inflation gap (the inflation rate minus the inflation target). Simulations show that this and similar rules stabilize inflation and real GDP even better than the decisions of expert committees, says the brief.