Higher interest rates looming

Interest rates are not going up next week when the Bank of Canada (BoC) announces their next interest rate decision.

That's the good news, or at least it's good news if you like to borrow at low rates. The bad news is that this sweet spot of decent economic activity and very low borrowing rates is likely to be short-lived, so start planning for what comes next.

The BoC has a lot on its plate.

It's worried about the Canadian housing market, which is either just about in balance or too hot or in a dangerous bubble, depending on your view. However you slice it, however, when sales and prices sky-rocket the way that they have done lately, responsible central banks tend to raise rates -- all things being equal.

In the BoC's case, however, the scope to raise interest rates is not really there. The U.S., our largest trading partner, just issued a dreadful jobs report and even Federal Reserve Chairman Ben Bernanke doesn't believe things are turning around quickly. Europe is in crisis -- and even China is slowing down. The BoC has to be mindful of all that if they are going to move. For one thing, even a hint that they might raise rates when no one else is going that route would likely send the loonie even higher than its current just-about-parity-with-the-U.S. rate.

Then again, the rosy numbers keep rolling in.

Last week, we learned that the Canadian economy added more than 80,000 jobs in March. This week, we found that builders were starting housing (particularly multiple-unit housing) at a crazy pace -- 220,000 starts (annualized) for the month of March. And the BoC's own surveys showed that credit was flowing and businesses were upbeat.

So how to decide policy? Well for the BoC, what it partly comes down to is that old central bank favourite: the 'output gap.'

The 'output gap' basically tracks how close were are to full production -- something along the lines of all the factories humming and all the would-be workers at work. For the BoC to get the economy to that level or close to it, but not let things go to the point where pricing pressures are being created, is tricky.

Last time they made a rate announcement (in January) the BoC said that that the output gap would 'close' by the third quarter of next year. That was a hint that interest rates would probably have to start rising ahead of that in order to make sure things were not getting too hot. Now, however, the evidence suggests it may not take that long for the output gap to close -- which might highlight the need for action even earlier.

Could we see a Canadian interest rate hike in 2012? Not necessarily, but it's time to weigh that possibility. In their statement, the Bank of Canada could well change their language and their projections -- just to get everyone warmed up to the idea of higher rates.