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OTTAWA (Reuters) - The Bank of Canada should raise interest rates now because five years of low rates are creating distortions in the economy, such as excessive debt and an overheated housing market, a former adviser to central bank Governor Mark Carney said on Wednesday.
In a hawkish stand at odds with most economists and market players, Paul Masson, now a professor at the University of Toronto's Rotman School of Management, said the central bank should tighten monetary policy to lean against asset price bubbles rather than focus exclusively on inflation.
Masson was Carney's special adviser from 2007 to 2008 and a senior official at the bank's monetary and financial analysis department in the early 1980s.
The bank next sets rates on May 29. It has held its benchmark rate at 1 percent since September 2010.
"Some of the symptoms of inefficient investment and asset price bubbles are already evident in Canada, in the housing sector for instance," Masson said in a paper published by the C.D. Howe Institute, a think tank.
"The cumulative effect of artificially low interest rates also risks fueling an underlying inflationary process. ... Therefore, the Bank of Canada should start now to reverse some of the monetary stimulus and begin raising interest rates."
The May 29 policy meeting will be Carney's final rate decision before he steps down to head the Bank of England. Stephen Poloz, head of Canada's export credit agency, takes over as Bank of Canada governor in July.
Masson said financial imbalances and risky investment decisions are spreading. In addition to the overheated housing market, he cited record-high levels of household debt.
"The longer the boom lasts, the more likely it will end in tears," he wrote.
Figures released on Wednesday point to a slowing housing market, with prices rising a modest 2.2 percent in April, the smallest gain in more than two years.
Masson said Canadians living off the interest income on their investments are moving to riskier high-yield investments, making them more vulnerable in case of a downturn. Inflation is not an imminent risk, but history suggests it could return quickly, he argued.
In a Reuters poll in April of 36 analysts, the median forecast was for a Bank of Canada rate hike in the third quarter of 2014. Only one out of 36 forecasters predicted a hike as early as the fourth quarter of this year, and a minority predicted an upward move in the first half of next year.
Canada recovered relatively quickly from a 2008-09 recession, and in 2010 the central bank was the first in the Group of Seven rich nations to raise rates, lifting them from the crisis low of 0.25 percent to 1 percent.
Carney has signaled for the past year that the next move would be up, but the timing of any tightening has been steadily pushed further into the future given sluggish growth and the uncertain outlook for the United States and Europe.
Masson acknowledged signs the housing market was cooling and that inflation is well below the central bank's target, and he sympathized with the Bank of Canada's caution in raising rates.
"After five years of low rates, however, problems are building for the Canadian economy that make it vulnerable to a future crisis."
Reporting by Louise Egan; Editing by Janet Guttsman and Leslie Adler