In its rate announcement earlier this week, the Bank of Canada sounded a surprisingly hawkish tone, causing some economists to revise their expectations for rate hikes from the bank. On Friday, central bank governor Mark Carney seemed to hint that it didn’t mean to sound quite so sanguine about the risks facing the recovery.

That the bank raised rates 25 basis points earlier this week wasn’t a surprise; what was a surprise to some commentators was that it seemed to downplay the downside risks facing the economy. And so, some economists abandoned their expectation that the bank would pause in its rate hiking moves, and changed their calls to predict more hikes this year.

On Friday, however, in a speech to the Spruce Meadows Changing Fortunes Round Table in Calgary, Carney revisited some of the downside risks that economists had expected to see in the policy announcement accompanying the rate decision.

“The current outlook is for continuation of a modest global recovery, balancing stronger activity in emerging market economies with weaker growth in some advanced economies. However, there are non-negligible risks on the downside,” he said.

“In particular, the current functioning of the international monetary and financial systems is beginning to force a wrenching real adjustment across major economies. Renewed weakness in the United States could have important implications for the Canadian outlook,” Carney noted, adding, “In this environment, the bank will have to chart a careful course for Canadian monetary policy. Any further reduction in monetary policy stimulus would need to be carefully considered in light of the unusual uncertainty surrounding the outlook.”

That discussion of downside risks seems to some as an effort to remind the market that it hasn’t forgotten about these risks, and that more rate hikes this year aren’t a sure thing. In a research note, Bank of America Merrill Lynch, indicates that the speech “may be signaling that investors took the Wednesday policy statement as too hawkish.”

More important, Merrill suggests, is what was not said in Carney’s speech on Friday. “There was no corresponding mention today of the ‘exceptionally stimulative’ financial conditions which prompted the sharp sell off in fixed income markets on Wednesday. The implication is that Carney may believe the move in the market post the rate announcement was too aggressive and that there is more of a downside skew in the bank’s risk bias than the market is currently discounting,” it says. Merrill forecasts that the bank will be on hold for the rest of the year.

In the rest of his remarks, Carney discussed financial sector reform in response to the financial crisis. He noted that the crisis exposed the frailties of the international financial system, including: global banks that were “woefully under-capitalized;” market participants that were too cavalier about liquidity; incentives at financial firms that caused too much risk taking; and financial regulation that was “neither well-conceived nor well-coordinated.”

Carney added that while extremely stimulative fiscal and monetary policy has bought the world some time, “a durable solution requires a rebalancing of global supply and demand, which will not happen without changes to the functioning of both the international monetary and financial systems.”

He suggested that the current recovery is at risk unless policymakers follow through on the reforms agreed among the G20. Absent those reforms, the bank has estimated that global economic output could see a shortfall of $7 trillion by 2015. While the latest G20 summit secured agreement on many of the right measures to make up this shortfall, Carney said, “the only measures that have actually been implemented have been consistent with the deflation path. While the other right promises have been made, conviction is required.”

“Adjusting to the current forces in the global economy requires finishing financial reforms, implementing greater exchange rate flexibility, and putting in place a series of structural policies,” he said. “G20 nations have started, but completing the job will require renewed faith in an open, flexible, and market-based international monetary system.”

IE