Jeremy Torobin, The Globe and Mail - September 30, 2010

The economy will grow at a "modest pace" in the coming months amid headwinds from abroad, and as Canadian households try to attack the debt that emergency low borrowing costs allowed them to pile up during the recession, Bank of Canada Governor Mark Carney warned Thursday.

While Canada's recovery has been the envy of the Group of 7, it has relied on levels of consumer spending and investment in housing that are proving unsustainable, Carney said. Both areas of the economy have slowed since the first quarter of this year as interest rates began climbing again and as worries mounted over the health of Canada's main export market.

A report Thursday from Statistics Canada showed the domestic economy contracted in July for the first time since August of 2009.

Carney gave further hints that he may pause his interest rate hiking campaign on Oct. 19 after three consecutive increases, repeating a comment from last week that there are limits to the "divergence" between the Bank of Canada's policy stance and that of the U.S. Federal Reserve.

And in a reminder of the issues facing the Group of 20 leaders when they meet in Korea this November, Carney said the global recovery is entering a phase that's "unusually challenging'' for countries like Canada that are caught between highly indebted advanced nations and emerging powers that must take measures for the good of the world economy but that could restrain their own expansion.

"The unusual uncertainty surrounding the outlook warrants caution,'' Carney told a business audience in Windsor, Ont. "With risks of a renewed U.S. slowdown, with constraints beginning to bind growth in emerging economies, and with domestic considerations that will slow consumption and housing activity in Canada, any further reduction in monetary policy stimulus would need to be carefully considered.''

Although the Canadian labour market has recouped all of the 400,000 jobs lost during the downturn, Carney noted the rebound has been somewhat less impressive than it seems. Speaking in a city where the unemployment rate is 3 percentage points higher than Canada's national rate of 8.1 percent, he added to nagging concerns that only about half of the new jobs are in the private sector, many workers who lost full-time jobs are being forced to take part-time employment, and a measure of hours worked has yet to return to pre-crisis levels.

That will turn around over time and part-time workers who want full-time jobs should eventually be able to find them, Carney said. But, he warned, both developments depend heavily on conditions south of the border and on increased investment by Canadian companies.

"The bank expects that average hours worked will return to its trend, but only very gradually,'' he said. "If the U.S. falters or the acceleration in Canadian business investment flags, then the pace of improvement in the labour market will be slower.''

Economists predict the central bank will step onto the sidelines next month, leaving the benchmark lending rate at 1 percent, and explain the move in detail through a quarterly forecast it's set to release the following day. Carney's July estimate of 2. 8 percent growth for the third quarter, they note, looks increasingly unlikely after the economy dipped 0.1 percent in July.

At the same time, Carney and other policy makers are walking a delicate tightrope between worrisome signs of endlessly tepid growth in the United States, and what the central bank calls an "exceptionally stimulative'' interest-rate environment at home that has sent Canadians' debt levels soaring to record highs.

"Historically low policy rates, even if appropriate to achieve the inflation target, create their own risks,'' Carney said. "Aside from monetary policy, Canadian authorities will need to remain as vigilant as they have been in the past to the possibility of financial imbalances developing.''