Interest Rate Hike, Dollar Parity Closer as Inflation Jumps

The countdown to an interest rate hike is on. Expectations of a rate rise grew even stronger Friday after official figures showed that the cost of living is rising faster than it should be.

The surprising news caused the Canadian dollar to jump above US99 cents as investors began to bet that an interest rate rise is close at hand. With the way the Canadian economy is going, it looks like U.S. dollar parity is inevitable.

The Bank of Canada has previously promised it would keep the key interest rate on hold at the record low level of 0.25% until at least the end of June, but the promise came with a 'Get Out of Jail Free' card that basically says it can raise rates sooner if inflation, or the rising cost of living, becomes a problem.

High inflation is something that could be much worse for Canada than a recession because it means that all that money sitting in your bank account and that weekly pay cheque are worth less. Basically, your money won't buy as much as it used to.

Luckily, inflation is not yet a problem, but the data showed that if something is not done - that is, an interest rate rise from the unnaturally low 0.25% level to slow price growth - then it could spiral out of control. So when can we expect a rise?

Many economists believe the Bank will keep its promise and not hike interest rates until July, but a growing chorus think there is a growing chance they will be forced to act sooner and protect the economy from inflation, particularly following the latest results.

So what happened? Consumer prices rose 1.6% in the 12-months to the end of February, largely because of higher gas prices and more expensive travel and accommodation costs due to the Vancouver Olympics. The Olympics look to have made prices higher than usual and it is likely accommodation prices in Vancouver will ease up now the Games are over.

Even so, prices are still climbing faster than expected because when you strip out some of the volatility, prices were up 2.1%. The Bank of Canada calls this less-volatile measure the 'core rate', and it is the main measure it looks at when assessing whether the economy needs an interest rate rise. As a rule, the Bank likes to keep this rate at 2%. So as you can see, the core rate is already above the Bank's target, so there is a chance they might need to jump in a little earlier to stop the core rate rising too high. It is unlikely though that they will do this next month because they will probably want to see how big or lasting an impact the Olympics had on prices.

So will inflation become a problem? It is unlikely. The Bank of Canada did a good job at slashing interest rates fast to help the ailing economy when the financial crisis and recession hit, and it is just as likely that they will hike rates appropriately if they think the cost of living is getting too high. What is clear is that the benchmark interest rate can't stay at 0.25% for much longer.

The next interest rate announcement is on April 22.