UPDATE 2-Bank of Canada sees 'neutral' rate lower than before

Mon Sep 22, 2014 2:44pm EDT
 
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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.   Continued...