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(Adds background, reference to Krugman position)
By Alastair Sharp
TORONTO, Sept 22 (Reuters) - Interest rates may have to be about one-and-a-half percentage points lower than they have been historically in order for the Canadian economy to operate at full capacity, the Bank of Canada said on Monday.
The central bank estimated the neutral rate of interest, or the rate at which the economy can work at full capacity with stable inflation, is now 3 to 4 percent, down from a range of 4.5 to 5.5 percent in the mid-2000s.
Bank of Canada Senior Deputy Governor Carolyn Wilkins said potential output would be lower than in the years leading up to the 2007-09 financial crisis. Global savings and new financial regulations requiring more safe-haven assets would also affect rates.
"All told, we think that the neutral rate of interest is lower than it was in the years leading up to the crisis because of these structural developments," she said in a speech unveiling the bank's conclusions. (bit.ly/1tVS964)
It is also possible that a persistent headwind might mean rates have to be lower than the neutral rate even after the output gap has been closed, to keep inflation on target, she said.
Wilkins said that in order to narrow the output gap, current policy needs to continue to be stimulative, relative to the neutral rate of 3 percent to 4 percent.
"But even with a closed output gap and inflation at target, the policy rate may not be neutral. As long as the factors leaning on growth persist, a policy rate below neutral would be required to maintain inflation sustainably at target," she said.
Household imbalances are the top of the bank's list of vulnerabilities, she said, but reiterated that hiking interest rates is not the primary tool to address these risks. Wilkins also warned of the risk that a premature withdrawal of monetary stimulus could undermine expansion - just as in 1937 as the U.S. economy was trying to exit the Great Depression.
The bank's estimate of the neutral interest rate has fallen steadily in recent years. In 2006, it estimated it was 5.25 percent, and in 2010 it pegged the neutral rate at 4.75 percent.
In real, inflation-adjusted terms, the bank estimates the neutral rate to be 1 percent to 2 percent. However, the bank also acknowledged the view that the world economy is suffering from "secular stagnation," and that the real neutral rate of interest could actually be negative.
"While we cannot completely discount this possibility, we believe that in Canada, the real neutral rate is still positive and that globally, monetary conditions are generally stimulative, although they vary across countries," she added.
One of the proponents of the secular-stagnation theory is Nobel Prize winner Paul Krugman, and Wilkins pointed to a paper he presented in May advocating higher inflation targets.(bit.ly/1mCVEO5)
But she said that this could entail the costs of higher inflation and risk stoking financial imbalances. (Writing by Randall Palmer and Leah Schnurr in Ottawa; Editing by G Crosse and Marguerita Choy)