Date: Friday, February 26th, 2010

The recent increase in the US Fed Discount Rate means very little in practical terms. The discount rate is the interest rate that the Fed charges banks for emergency loans and it is hardly being used. The rate hike however, signals the first step in a long journey towards removing liquidity from the system.

The move makes sense given that the Fed has closed many of its emergency lending facilities and demand for funding has slowed substantially. In fact, borrowing from this credit facility has totaled only $20 billion over the past three months. Given that normally the gap between the discount rate and the fed funds rate is 100 basis points and today, it is standing at 50 basis points suggests that we might see an additional increase in this rate in the near future. What counts, however, is the fed funds rate and this rate is unlikely to rise until early 2011.

As for the Bank of Canada, at this point it appears that the Bank is committed to start hiking come June or July. This is a risky move given that both in 1992 and 2002 the Bank moved independently of the Fed, only to reverse the decision a few months later. The most likely scenario is that the Bank will move by 50-75 basis points and then will pause until 2011 and continue to hike alongside the Fed.

The reason for the limited hike in 2010 is that the ongoing recovery in the Canadian economy will not be linear. The first two quarters of the year will be strong, reflecting fiscal stimulus from both sides of the border, a rebounding inventory cycle and strong credit growth in Canada. These factors, however, will fade in the second half of the year, with overall GDP growth expected to average less than 2% vs. more than 3% in the first half.

As for inflation, the Bank of Canada is projecting core inflation to reach its target rate of 2% by mid-2011. But the core rate has already reached 1.9% last month. Is the Bank of Canada wrong? The short answer is no. The 1.9% advance in the core rate reflects a very soft base period (rates are calculated on a year-over-year basis and January of 2009 saw a notable decline in prices). This means that the coming months will see a much lower inflation rate. The reality is that the underlying inflation rate in Canada is well below 1.5%. So we still have a lot of time until we reach the Bank’s target.

The recent move by the Ministry of Finance towards more stringent regulation of home loans is targeted to deal with potential problems down the road without derailing the housing market.

Lawrence Kobescak

Lawrence Kobescak

Lawrence Kobescak, the creator behind is a real estate sales representative, mortgage agent and real estate investor. has reached over 240,000 Canadians since 2009. Lawrence has been quoted in the Globe & Mail and

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