February 8, 2016 / 5:17 PM / in 2 years

UPDATE 2-Bank of Canada: cannot take lead in maintaining financial stability

(Adds details from speech, comments on Fed, background)

By Jonathan Montpetit

MONTREAL, Feb 8 (Reuters) - Central bankers cannot take primary responsibility for upholding financial stability because interest rates are too blunt an instrument to address potential problems in just one part of the economy, a Bank of Canada official said on Monday.

Record high consumer debt and hot housing markets in some Canadian cities have fueled worries that over-extended borrowers pose a risk to the financial system.

But Bank of Canada Deputy Governor Timothy Lane noted that while stimulative monetary policy might cause vulnerabilities to build up over time, failing to ease in an economic downturn could worsen the contraction, causing a crisis.

The central bank cut interest rates twice last year as collapsing oil prices pushed the country into a mild recession.

“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,” he said.

He made the case for macro prudential tools, such as government tightening of mortgage regulations, to promote financial system safety, allowing the central bank to focus on inflation.

The Liberal government announced in December it would force people who want to buy more expensive homes to provide a bigger downpayment. The former Conservative government made similar moves.

In Canada’s case, there has been a tension between cutting rates to stimulate growth and the disproportionate boost that would have on rate-sensitive sectors such as housing, Lane said.

Bank research estimates that increasing rates 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 hold inflation down by 0.5 percentage point compared to where it would otherwise be.

“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.

Lane said that in a situation of sustained weak demand in the economy, fiscal policy may be needed to provide stimulus, particularly as it is likely to be more effective at low interest rates.

The bank said in January it had not included in its forecasts the positive impact of the fiscal stimulus promised by Prime Minister Justin Trudeau in the upcoming federal budget.

Lane reiterated the bank is not obliged to follow the U.S. Federal Reserve, which raised rates in December. (Reporting by Jonathan Montpetit, writing by Leah Schnurr and David Ljunggren; Editing by Chizu Nomiyama)

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