UPDATE 1-IMF sees limited room for Bank of Canada rate cut

Mon Feb 3, 2014 11:38am EST

By Louise Egan

OTTAWA Feb 3 (Reuters) - The International Monetary Fund (IMF) said Monday Canada's central bank is likely to hold its main interest rate steady until early 2015, and the bank has limited room to cut rates because of overvalued housing prices and record household debt.

After consultations with Canadian officials on the state of the economy, completed in late January, the IMF concluded the Canadian economy will pick up speed in 2014 as exports get a lift from stronger U.S. growth.

It highlighted concerns that growth remains too reliant on consumer spending and homebuilding, but it sees exports and business investment gradually taking over as the main drivers of growth over the next couple of years.

"Monetary policy should remain accommodative until there are firmer signs that growth is picking up above potential, with a sustainable transition from household spending to exports and business investment," the Washington, D.C.-based lender said in its report.

The IMF's projections assume the Bank of Canada's overnight target rate will start increasing in "early 2015" and rise to 4 percent by 2019. Analysts in a Reuters poll conducted just before the bank's Jan. 22 rate announcement predicted the bank's first rate increase would come in the second quarter of 2015.

The bank has kept rates at 1.0 percent since September 2010, but last month it revealed a growing concern about chronically weak inflation, prompting some market players to increase their bets on a rate cut at some point this year.

While the IMF acknowledged a recent cooling of the housing market and household debt, it warned that these problems could flare up again if the bank eases policy.

"The existence of domestic imbalances, however, reduces the room for lowering the policy rate despite the recent moderation in the housing sector and household borrowing," it said.

The IMF sees inflation returning to the central bank's 2 percent target by the end of 2015, roughly in line with the bank's outlook.

Average house prices in the country are still overvalued by 10 percent, the IMF estimated, saying prices were high relative to income and rents, compared with historical averages, and compared with prices in many other advanced economies.

As a long-term goal, it urged Ottawa to reduce its exposure to mortgage insurance through the government-owned Canada Mortgage and Housing Corp (CMHC), stressing that this process should be gradual to avoid market disruption.

The federal government guarantees 100 percent of CMHC's insured loans, and CMHC has a 75 percent share of the mortgage insurance market in the country.

A separate IMF report assessing the stability of Canada's financial system, also released on Monday, identified mortgages and consumer loans secured by real estate as the single largest source of exposure for banks.

The IMF sees the Canadian economy growing by 1.7 percent in 2013, rising to 2.2 percent in 2014. The Bank of Canada's 2014 growth forecast is a slightly higher at 2.5 percent.

WEAKER C$ AND EXPORTS

The IMF suggested the recent depreciation of the Canadian dollar against the U.S. dollar had not given the lift to exports that it normally would.

"In particular, despite the depreciating exchange rate, non-energy exports remained well below the levels reached after earlier recessions," it said.

The Canadian dollar has fallen sharply since the central bank adopted a more dovish tone last October, and it hit a 4-1/2-year low last week.

The IMF report looked at the depreciation relative to a basket of other currencies and said the Canadian dollar was 10 percent overvalued, on average, in the first 10 months of 2013.

Roberto Cardarelli, the IMF's mission chief to Canada, later said on a conference call with journalists that the currency fell by about 5 percent in 2013 overall in real, effective terms and was still somewhat overvalued.

"It is moving in the right direction. Our 10 percent overvaluation is probably right now a little bit lower," he said. "I think what happened over the last two or three months may have reduced the degree of overvaluation but not totally erased it."

It's too early to say what impact the weaker currency will have on exports, he said, with stronger U.S. demand likely to be the main driver of export growth.

A decade of a strong currency and low productivity rates may have done long-lasting damage to the export sector.

"As you know, there are other headwinds that we think are still at work, that are more structural in nature. This loss of competitiveness, it's something that concerns us. It's something that concerns the authorities as well," said Cardarelli.

The IMF also had some advice for Finance Minister Jim Flaherty as he prepares to deliver the federal budget on Feb. 11. The lender applauded Ottawa's steps to eliminate the budget deficit and sees it on track to achieve that in the 2015-16 fiscal year with little effort. It added, "there is room to delay the adjustment needed to return to a balanced budget in 2015 if there is no meaningful pickup in economic growth."

Growth of less than 2 percent a year would be cause for rethinking the timeline for balanced budgets, said Cardarelli.

The federal deficit is seen shrinking to 0.4 percent of gross domestic product (GDP) in 2014 from 0.8 percent this year, but when provincial government deficits are included, the gap is 3.1 percent of GDP this year and 2.6 percent in 2014.