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By Jonathan Montpetit
MONTREAL, Feb 8 (Reuters) - Central bank policy cannot take the primary responsibility for maintaining financial stability, with interest rates being too blunt an instrument to address an imbalance in one part of the economy, Bank of Canada Deputy Governor Timothy Lane said on Monday.
While Lane noted that stimulative monetary policy might cause vulnerabilities to build up over time, he said failing to ease in an economic downturn could worsen the contraction, causing a crisis.
Lane laid out the case for macro prudential tools to be used to promote the safety of the financial system, allowing for monetary policy to target inflation.
"Monetary policy cannot take primary responsibility for maintaining financial stability," Lane said in a prepared text of a speech. "Other prudential tools are required to build a resilient financial system and, where needed, to address increasing vulnerabilities."
After cutting rates twice last year to offset the pain of the oil shock, the bank held steady at its most recent rate decision last month, partly out of concern of the impact of the rapid drop in the Canadian dollar.
The bank's easing last year led to concern the low borrowing costs would exacerbate already high household debt as home prices have climbed in parts of the country.
Research at the bank estimates that increasing the bank's policy rate by 1 percentage point for one year would reduce household debt by 2 percent over five years, Lane said, but the same increase might cut output by up to 1 percent and push inflation down by 0.5 percentage point compared to where it would have been otherwise, Lane said.
"These results suggest that, even though monetary policy could, in principle, be used to reduce vulnerabilities in the financial system, it may be too costly in practice," he said.
"Interest rates affect all parts of the economy and are too blunt an instrument to address an imbalance in just one part of the economy - household credit."
Lane said the bank has been doing research to improve its understanding of the relationship between monetary policy and financial stability, which is a key question in the central bank's renewal of its inflation control agreement with the government this year.
Markets are pricing in about a 76 percent likelihood the bank will hold at its next meeting in March. (Reporting by Jonathan Montpetit, writing by Leah Schnurr and David Ljunggren; Editing by Chizu Nomiyama)