Softer than expected inflation in August has prompted leading analysts to suggest that the Bank of Canada should perhaps hold interest rates steady during the coming months.

Statistics Canada reported last week that the headline inflation rate was 1.7% in August on a year-over-year basis, while month-over-month consumer prices slipped 0.1%. Meanwhile, the core rate — which strips out volatile-priced items such as food and energy — remained unchanged at 1.6% in the month. Market consensus was for a headline rate of 1.9% and a core reading of 1.7%.

The figures indicate inflation poses no threat to the economy, and at present consumer price increases are running below the Bank of Canada’s forecast. For instance, analysts indicate the core rate — which the central bank closely watches because it excludes volatility — will come in lower than the Bank of Canada’s forecast for 1.8% in the third quarter of 2010.

Taking into account that the central bank sets its policy rate in an effort to attain and maintain 2% inflation, these figures have analysts suggesting that the Bank of Canada might refrain from raising its benchmark rate again at its next meeting on Oct. 19.

The Bank of Canada has raised rates by 25 basis points at each of its last three meetings, as Canada recovered strongly from the recession. However, growth has ebbed as of late, due to a slowdown in the U.S. and global economies. Second-quarter GDP expansion was 2% annualized, down from the 5.8% reading in the first three months of 2010.

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Developments in the global economy, such as the speed at which debt-laden governments are forced to cut spending and the drag that could entail for worldwide growth, means further interest-rate hikes in Canada are not “preordained,” Bank of Canada bank governor Mark Carney said Wednesday.

In remarks delivered in Charlottetown, Prince Edward Island, Carney said “considerable uncertainties” remain in the global economy, and the eventual paring back of debt among households, banks and countries “have barely begun, and will add to the variability and temper the pace” of global growth.

“The current economic outlook is neither as robust as recent data indicate nor as dire as current headlines scream,” he added.

Keeping that in mind, he said future rate hikes following the June 1 increase by 25 basis points, to 0.50 per cent, would depend on both the domestic performance as well as the “uneven” global recovery, something the central bank suggested in its June 1 statement.

“In light of the scale and volatility of these conflicting forces,” Carney said in Charlottetown, “it should be evident that no particular path for monetary policy is preordained.”

That remark was not in the interest-rate statement from June 1, and would suggest Carney is keen to keep his options open as to what the Bank of Canada would do at its next rate decision, scheduled for July 20.

In June, the central bank raised its benchmark rate based on stronger-than-expected domestic growth, with annualized GDP expansion of 6.1 per cent for the first three months of 2010. Further, inflation was above the bank’s expectations and hovering close to its preferred two per cent target.

Europe’s fiscal and financial health remains cause for concern among policy makers and investors — and on Wednesday the focus was on Spain.

The Financial Times reported Spain’s banks borrowed record amounts from the European Central Bank last month. Plus, there were rumours — later denied — that Spain was in talks with the United States, International Monetary Fund and the European Union to get access to additional funds through a line of credit.

Carney said recent financial tensions in Europe “are likely to result in higher borrowing costs and more rapid tightening of fiscal policy in advanced economies . . . . Without countervailing policies, this could lead to a more protracted recovery.”

Those policies include efforts among Group of 20 economies — whose leaders meet in Toronto next weekend — to address the unwinding of global trade imbalances to ensure sustainable and balanced growth; credible plans to get budget deficits to more manageable levels; liberalized exchange-rate policies, especially in emerging Asian economies; and financial reforms that would require banks to hold more capital and limit leverage.

“The possible responses of . . . countries to the situation are denial or conviction,” Carney said. “In the former, growing public debt will push up global interest rates (by up to 300 basis points), crowding out private investment and lowering potential growth.”

He warned of options being floated by some commentators, in particular the possibility of allowing temporarily higher inflation in order to inflate away public debt.

“To the bank, this is a siren call,” said Carney, whose central bank sets interest rates with the goal of achieving two per cent inflation.

“Central banks have worked for decades to get inflation down to levels consistent with price stability. We should not risk those hard-won gains.”

However, he said Europe has shown “conviction” in terms of its nearly $1 trillion U.S. financial stabilization plan, resulting in some key countries — Greece, Spain and Portugal — introducing tough austerity measures. Britain is to follow, shortly, as well.

“However,” Carney added, “the age of austerity carries its own risks.” He said budget-cutting plans that are too aggressive and introduced too early could create a sharp shortfall in global GDP — of about $7 trillion U.S., the central bank estimated, assuming the absence of no exchange-rate adjustment and higher domestic demand elsewhere.

Below are some of the highlights of Carney’s speech in Charlottetown:

ON BIGGEST RISK TO CANADIAN ECONOMY

“Canada is not an island … The biggest risks we face are from abroad. Those are the biggest swings.”

“I firmly believe that there is considerable opportunity outside of the U.S. and outside of Europe that needs to be exploited and should be exploited.”

ON THE CANADIAN HOUSING MARKET

“We said in our most recent projection that we expected housing market activity to slow markedly over the balance of the year … the latest (housing resale) numbers are consistent with that.”

ON FINANCIAL REFORM

“It’s extremely important that the G20 focus on the core elements of reform … capital, liquidity, the so-called Basel III package. It also matters that we get new resolution regimes, make progress on addressing ‘too big to fail’ and eliminating the moral hazard that is built up in the system. Related to that, it’s extremely important that new infrastructure is put into core markets including derivatives and funding markets so the system as a whole is more resilient.”

“The more we focus on that core agenda, the more agreement there is, the more progress we’ll make. I would say that the Basel process is very much on track.”

ON LABOR MARKET

“(There are) encouraging signs in the labor market that employment growth has returned, still a ways to go on the hours worked. There is still considerable … slack in the economy.”

ON FISCAL CHALLENGES

“The fiscal challenges that face a number of advanced economies are addressable, but they are addressable with bold action and that was part of the point of the speech. That is very much part of the point of one of the core objectives for Canada at the G20 summit.”

ON SUSTAINABLE DEBT LEVELS

“Sustainable debt to GDP is different in different economies and it is partly a function of the potential growth of the underlying economy … So all things being equal, having stronger underlying growth allows you to sustain a higher level of debt.”

ON THE U.S. CONSUMER

“The U.S. consumer has to get their balance sheet back in order and the strength we have seen in consumption spending, which has not been that robust in the United States, has been largely aided by a series of government measures … But that is going to come off over the balance of this year and into 2011, and we are going to see unaided consumption in the United States, which is going to be weaker than it has been previously.”

ON PERSONAL FINANCES

“We are getting to elevated (debt) levels and the bank has been warning on this issue and urging people to ensure that their personal finances are in order for a normal interest rate environment,”

ON PROVINCIAL FINANCES

“Provincial finances are incredibly important for our overall dynamics and the same rules apply to the provinces as to countries. They need to have credible fiscal plans to return to sustainable levels of borrowing.”

ON INFLATION OUTLOOK AND FISCAL CONSOLIDATION

“A scenario where all countries or all advanced countries tighten fiscal policy quite quickly in the face of market pressure, but other measures are not taken, that is clearly disinflationary, it clearly will slow the pace of global growth, it will have an implication for Canada, a material implication for Canada, and central banks will need to react.”

“The bank has a wide range of options and … flexibility for how we would react and maintain our ability to achieve our 2 percent inflation target. That is not our central scenario. We’re working hard to make sure that the pace of fiscal consolidation is both orderly and credible and that’s one of the objectives when we sit around the table with these countries at G20 meetings.”

Taking on a mortgage is a big commitment. Every buyer who uses a mortgage has the choice of floating or going with a fixed rate. The cost of making a decision to float or go fixed varies with the rate differences.

In 2008, Moshe Milevsky, Associate Professor of Finance at the Schulich School of Business at York University, and Brandon Walker, a research associate at the Individual Finance and Insurance Decisions Centre in Toronto, published a study that measured the direct and opportunity costs of going with either choice. “Over the long run, homeowners really do pay extra for fixed rate mortgages,” they concluded.

The reason is intuitive. Lenders do not want to take the chance that when they have to refinance a loan that they will be stuck paying more than they are getting.

Mismatching what they lend with the cost of what they borrow can cut their profits and even lead to insolvency. So lenders attach what amounts to an interest rate insurance fee and bundle that into the price of money they lend on fixed terms.

Milevsky and Walker confirmed this explanation. “The study showed that a positive Maturity Value of Savings [the value of investing the difference between floating and fixed mortgages in 91-day T-bills] was positive the majority of the time, so the homeowner saved by using a variable-rate mortgage.”

The amount of money that the homeowner can save by taking a chance on floating rates varied in the Milevsky and Walker study, depending on the time periods in question. But the average amount was impressive: $20,630 as of 2008. Put another way, floating allowed borrowers to cut the time it would take to pay off the mortgages by a year or more, in some cases as much as five years on 15-year amortizations.

There are other strategies that the buyer can use to provide some rate insurance without taking on what Milevsky and Walker have demonstrated as the high cost of peace of mind, such as taking a variable rate mortgage but set payments higher than the minimum required. That could be at the 5 year closed rate, which would mean a faster pay-down and growing asset security while still keeping the low cost of the variable rate mortgage. Faster pay-down is itself cost insurance if interest rates do rise.

Plan selection, it turns out, is gender-related. According to a BMO survey, men, 44% of the time, are more likely than women to choose a fixed rate mortgage than women, who make that choice only 28% of the time. Women, it turns out, tend to make the better choice, for as BMO’s analysis shows, “fixed rates were advantageous during only two periods – through the late 1970s and in the late 1980s, in both cases ahead of a period rising interest rates, as is the case now.”

So where are interest rates headed? The yield curve, a line that links interest rates for periods of time from 1 day to 30 years, implies that rates will rise, but not very much.

There is no sense that we are returning to a period of double digit rates. Moreover, there are deflationary forces at work, notes Patricia Croft, chief economist of RBC Global Asset Management in Toronto. “The present crisis in European finance and the potential fizzling out of the present recovery in North American capital markets could presage falling inflation and even disinflation – the subsidence of rising prices and interest rates,” she explains.

The April inflation data shows that Canadian inflation accelerated more than expected in April, inching closer to the Bank of Canada’s 2-per-cent target in the last reading before policy makers’ June 1 interest-rate decision. Although the Bank of Canada is being very cautious in its interest rate management commitments, the reports re-fuelled speculation that Bank of Canada Governor Mark Carney will lift his benchmark interest rate next month from the current 0.25 per cent.

For those who are strapped for cash, personal circumstance may dictate the choice of a fixed rate. But for everyone else, the folly of trying to make interest rate predictions over a business cycle and to predict both the short term rates and the long term rates along the yield curve should be apparent. No promises, of course, but the odds of saving money are with borrowers who choose variable rate plans or those that emulate them.

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