Financial vulnerabilities could undermine effect of rate cuts: Bank of Canada

Financial vulnerabilities like high household debt could undermine central bank efforts to keep inflation in check, since they potentially limit the effectiveness of rate cuts, a top Bank of Canada official said on Thursday.

In a lecture to university students in Quebec City, Deputy Governor Paul Beaudry made no mention of future rate moves and said an environment where inflation was low, stable and predictable remained ideal.

Achieving that could become more challenging, however, given increased risks posed by vulnerabilities linked to balance sheets, asset prices and risk allocation, he said.

"The same policy choice that helps the central bank achieve its inflation target in the short run may be making it more difficult to attain its target in the longer run," Beaudry said.

Canada's central bank, which has sat on the sidelines for more than a year even as several of its counterparts have eased, held its overnight interest rate steady as expected on Jan. 22 but left the door open a possible cut if a recent slowdown in domestic growth persists.

After the speech, money markets saw about a 24% chance of a rate cut in March, while the Canadian dollar was trading at C$1.3207 or 75.72 U.S. cents.

"Beaudry's speech is more of an explanation about why the Bank has yet to cut rates in the face of a global slowdown and the subsequent cooling in Canadian economic momentum," said Royce Mendes, senior economist with CIBC capital markets.

The speech, he added, did not "explicitly state that vulnerabilities are too high to cut rates should the economy continue to underperform as we expect."

While lower interest rates could cause an initial boom in economic activity, that might well be followed by a later bust if the accumulation in household debt became a drag on consumer spending, Beaudry said.

Last October, the central bank's governing council discussed whether a rate cut was needed to insure against risks to the economy, but decided against easing.

"Given the state of the financial vulnerabilities in Canada, we judged the risk of reigniting the acceleration of house price expectations and the buildup of debt was too high - and that could make attaining our inflation target harder in the long run," Beaudry said.

The Bank of Canada's inflation target, which is up for renewal in 2021, is currently set at 2%.

By Kelsey Johnson