UPDATE 2-Bank of Canada sees limit to low interest-rate strategy

Thu Jan 10, 2013 6:01pm EST

* Macklem suggests outlook weaker than previously thought

* Says BoC may need to hike rates amid soaring personal debt

* Sees signs of moderation in housing, debt

* Macklem seen as strongest candidate for next BoC governor

By Randall Palmer

KINGSTON, Ontario, Jan 10 (Reuters) - High household debt is stretching the Bank of Canada's low interest rate strategy to the limit, Senior Deputy Governor Tiff Macklem said on Thursday, hinting that the central bank will retain its bias toward higher interest rates.

Macklem, considered the strongest candidate to be the next governor of the central bank after Mark Carney leaves later this year, said keeping rates low for the longest period since the early 1950s was the right thing to do during the global financial crisis and in its aftermath.

"It was the right thing to do... That strategy is reaching its limits and rising levels of household indebtedness have created a vulnerability," he said in response to a question from the audience following a speech at Queen's University in Kingston, Ontario.

Macklem said in his speech that the Canadian economy will likely be more sluggish than expected in the near term but that momentum will pick up throughout 2013.

"We continue to expect economic activity to pick up through 2013, but near-term momentum now appears to be slightly softer than previously anticipated," Macklem said.

"These and other developments will all be taken into consideration as we revise our economic projections, to be published on Jan. 23 with the next interest rate decision," he added.

The bank is expected to keep its benchmark interest rate on hold at 1.0 percent later this month. But it has been hinting for months that its next move will be up, not down and the debate in markets is just how soon it will act.

Market players surveyed by Reuters in late November forecast the bank would raise rates in the fourth quarter of this year. Yields on overnight index swaps, which trade based on expectations for the policy rate, show traders do not fully pricing in a rate hike this year.

In another hawkish sign, Macklem repeated comments by Bank of Canada Governor Mark Carney that in the current circumstances, the bank may want to set interest rates higher than would normally be warranted to reach its 2 percent inflation target within six to eight quarters.

He cited Canada's record high household debt as a factor that could influence the timing and degree of any rate increases.

"If the bank were to lean against such imbalances, we would clearly say we are doing so, and indicate how much longer we expect it would take for inflation to return to the 2 percent target," he said, echoing previous remarks made by Mark Carney, the bank's current chief.

Michael Gregory, senior economist at BMO Capital Markets, believes the bank's Jan. 23 announcement will keep its language on the need to raise interest rates.

"It will be retained even though the Bank's economic projection will be downgraded ... and the output gap, currently expected to close by the end of 2013, might be pushed into early 2014," he wrote in a note to clients.

Macklem's speech is being closely watched as he is widely viewed as the most qualified candidate to take over as governor after Carney leaves to be the next governor of the Bank of England.

Debt accumulation by Canadian consumers is slowing and if the trend continues the ratio of household debt to income - which hit a historic high of 163 percent in the third quarter of last year - will stabilize later this year, he said.

Fears of an overheated housing market are also starting to wane amid signs real estate activity is cooling. Macklem predicted housing construction would moderate to come in line with demographic demand at some point this year.

He warned though, that it was too early to tell if these trends would last.

While he stressed the bank's commitment to keeping inflation low and stable, Macklem also highlighted the need for flexibility in the time it takes to reach the inflation target. The global crisis taught us that price stability and financial stability are linked, he said, and one should not be pursued without keeping an eye on the other.

"It may be appropriate in some circumstances for monetary policy to complement macroprudential policy and contribute to financial stability directly.

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