June 13, 2012 / 2:08 PM / in 5 years

Canada may need to raise rates this year: OECD

OTTAWA (Reuters) - Canada should be ready to hike interest rates as soon as the fourth quarter of this year if the economy doesn’t turn sour, but it may need to slow down budget tightening if the economy does deteriorate, the Organization for Economic Cooperation and Development said on Wednesday.

The Paris-based OECD also said Canadian authorities may have to take measures to try to limit household indebtedness and cool the housing market if imbalances persist.

It said the Bank of Canada faces a delicate balancing act, with prolonged low interest rates raising concerns about risks for the financial system. There are also short-term risks to the economy resulting from deficit reduction and a strong currency, it added.

“We think that the Bank of Canada will have to return to its policy of withdrawing stimulus, starting fairly soon, probably in the fourth quarter, so as to head off an upward drift in inflation that is currently right on target,” Peter Jarrett, who is in charge of Canada at the OECD’s economics department, told reporters after the release of the organization’s report on Canada.

The Bank of Canada targets 2 percent annual inflation, and that was the inflation rate in April.

Jarrett emphasized that the OECD’s rate-hike scenario assumes that the European debt crisis will be contained and that Canada is not hit by contagion from it.

In the worst-case scenario of another global financial crisis and recession, he said the central bank could cut rates from the current 1 percent and prepare for possible quantitative and credit easing, reviving a plan it unveiled in the 2008-09 crisis but never used.

“Obviously it depends on how nasty, how tough things get out there but if it’s something of the same order of magnitude (as 2008), if there’s threats to the system, I think there’s no reason why the Bank of Canada would hesitate to go back and do at least what they did before, much less start doing something that is labeled quantitative easing,” Jarrett said.

“But they certainly have more room to cut rates if things get really tough,” he said.

Referring to federal and provincial government budget cuts, the OECD said: “This tightening is necessary to reduce the debt overhang resulting from the past recession and stimulus measures, but the authorities should slow the pace of consolidation if significant downside risks to growth materialize.”

The OECD said Canada’s housing market was “a risk worth worrying about” even though there has been some slight cooling in some areas.

Like the government, Jarrett sees the Toronto condominium market - where some 15 percent of completed condo projects remain unoccupied - as the biggest candidate for a crash.

“I understand that the minister and the governor’s warnings are starting to take some effect because lending institutions are now demanding that virtually the entire project be pre-sold before they’ll finance a condominium project,” he said.

“So I think if there is a correction it isn’t going to be as serious as it would have been. A drop in prices, which probably will take place, might be easily absorbable without massive problems in either the banking sector or the real estate development sector, but the concern remains.”

The survey projected real economic growth in Canada of 2.2 percent this year and 2.6 percent next year. By contrast, the Bank of Canada’s April forecast is for 2.4 percent growth in both years.

The large majority of the 128-page report was dedicated to the need to boost innovation to raise historically weak productivity growth to sustain living standards.

“Canada’s overall productivity has actually fallen since 2002, while it has grown by about 30 percent over the past 20 years in the United States,” the OECD said.

Reporting by Randall Palmer and Louise Egan; Editing by Jeffrey Hodgson; and Peter Galloway

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