Low-Inflation Risk Motivated Bank of Canada's Caution on Rates, Official Says

By Paul Vieira Features Dow Jones Newswires

The risk posed by low inflation and concern about households immediately paring back spending after two recent rate increases helped motivate the Bank of Canada to embrace a cautious approach in future policy decisions, the central bank's second-highest ranking official said Wednesday.

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Carolyn Wilkins, the Bank of Canada's senior deputy governor, provided further insight in remarks in New York about why the central bank opted to hold tight last month on rates after increases in July and September on the heels of strong growth. Besides inflation and indebted households, Ms. Wilkins cited stricter mortgage-financing rules and talks to revamp the North American Free Trade Agreement as areas of uncertainty prompting patience at the Bank of Canada.

Ms. Wilkins said chief among the central bank's concerns is inflation. The central bank sets interest-rate policy to achieve and maintain 2% inflation, or the midpoint of the target range. For the bulk of 2017, the annual inflation rate in Canada has remained below 2%, hitting a two-year low in June of 1% before climbing to 1.6% in September. Inflation figures for October are scheduled for release Friday.

"While some normal fluctuations can be expected within the target range, central banks may become disproportionately concerned about the prospect that inflation might fall outside the range," said Ms. Wilkins, according to a copy of prepared remarks. As a result, the central bank "puts a greater weight on the downside risk when inflation is low to begin with."

Inflation-targeting central banks tend to lower interest rates to help prices adjust whenever demand falters. If there is risk that excessive spending pushes inflation over the target, central banks tend to raise rates to cool growth.

Even if inflation were at 2%, Ms. Wilkins said, caution was likely in order due "greater uncertainty" related to how changes in interest rates flow through the economy. Generally, it is believed it takes 18 months to two years before the full impact of a rate change works its way through the financial system. In the current Canadian context, elevated levels of household debt "has likely heightened the sensitivity of spending to interest rate increases, [although] it is difficult at this juncture to know by how much," Ms. Wilkins said.

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She added it is also unclear how tougher mortgage-financing rules -- requiring all potential buyers to undergo a stress test before qualifying for a loan -- could weigh on consumer spending.

She added the central bank is focused on wage gains, which were tepid until recently, and the potential level of output, which measures how much an economy can grow before triggering inflation. Bank of Canada governor Stephen Poloz has said potential output might be higher than the bank estimates because firms have expanded capacity because of stronger demand.

Ms. Wilkins said central bank officials are also are following Nafta talks closely.

Write to Paul Vieira at paul.vieira@wsj.com

(END) Dow Jones Newswires

November 15, 2017 19:29 ET (00:29 GMT)