The rate-tightening cycle was begun earlier this year with a 25 basis point rate hike by the Bank, and is expected to continue tomorrow with another 25 bps hike. A series of hikes are expected through the rest of the year and into 2003.

“This re-balancing of monetary policy raises the important issue of how high interest rates can go before they begin to hamper economic expansion. While identifying the exact level is highly problematic, a reasonable case can be made that an overnight rate of 4.5% would virtually eliminate the stimulus from monetary policy.” TD says that the Bank of Canada will need to be near neutral by mid-2003 to stave off the risk of inflation. Although, the trick will be to define just when policy is in “neutral”.

Economic history suggests that neutral policy occurs when the real overnight rates are in the 2% to 3% range, says TD – probably in the upper half of that band. “Assuming that the Bank continues to target a 2% inflation rate, that puts nominal rates in the 2.5% to 5.0% range. Given current estimates that the output gap will be closed in mid-203, the implication is that the Bank of Canada has a considerable amount of tightening to deliver before rates become a hurdle to economic growth.”