Bank of Canada governor Mark Carney is defending the way the central bank sets interest rates, suggesting Friday that monetary policy can be used to address concerns about people taking on too much debt if it threatens the economy.
In a speech in New York, Carney said low interest rates over a prolonged period of time can cloud financial judgment and prompt companies and people to borrow too much for too long.
However, the central bank's framework allows for flexibility to address those concerns, he said in his speech, copies of which were released in Ottawa.
While the first line of defence is regulation and supervision, Carney said monetary policy can also be used to address imbalances that may have economy-wide implications.
"A virtue of flexible inflation targeting is that if the regime is credible the inflation target can anchor inflation expectations while leaving room for policy-makers to occasionally use monetary policy for financial stability purposes," he said.
Carney noted that Canadian banks are reinforcing their balance sheets to meet the Basel III requirements ahead of schedule and the federal government has tightened home mortgage financing rules to help prevent consumers from borrowing more than they can handle.
However, the Bank of Canada warned earlier this week that Canadians are becoming increasingly vulnerable to a housing correction.
The bank did not suggest a U.S.-style housing collapse for Canada, but noted that home prices have risen sharply in the past dozen or so years along with debt, as homebuyers have needed both bigger mortgages to buy homes and used equity from higher home values to finance other purchases.
The central bank has calculated that a 10 per cent drop in home prices could generate a one per cent decline in consumption, which would slow economic growth.
Carney's speech came ahead of a meeting of G20 finance ministers and central bank governors scheduled for the weekend where they are expected to focus on promoting global economic stability and growth.
The central bank recently completed a review of its monetary policy framework and reaffirmed its position on inflation targeting. Under its framework, the bank aims to return inflation to a medium-term target while limiting volatility in other areas in the economy.
However, Carney noted that flexibility in the time it takes to return inflation to the target rate cannot be arbitrary and needs a clear and transparent approach.
The U.S. Federal Reserve has said that its fed funds rate is expected to remain at exceptionally low levels at least through late 2014.
"Extraordinary forward policy guidance within a flexible IT framework helped the Bank of Canada provide additional stimulus when it was needed and should help the Fed do the same. The Fed's experience with a published interest rate path in conventional times, when they return, is something we will watch with interest," Carney said.
The Bank of Canada's key overnight rate has been set at one per cent for more than a year.
Inflation edged up in January to 2.5 per cent, boosted by an increase in gasoline prices. However, the underlying core inflation rate -- which excludes volatile items such as some fresh food and gas -- rose to 2.1 per cent, one tick higher than the Bank of Canada's target.
