Bank of Canada eyes low inflation; sees China risk up

By Alastair Sharp and Randall Palmer OTTAWA, (Reuters) - Canada's financial system is robust despite lingering concern about a stretched housing market and low inflation, while external risks from China have increased, the Bank of Canada said on Thursday. The bank's governor expressed persisting anxiety over low inflation, citing underlying price rises of around 1.2 percent, below the 2 percent registered in April for overall inflation. "After weighing the risks to financial stability through our improved framework and applying judgment, our level of comfort - or perhaps should I say our level of discomfort - as policy-makers remains similar to what it was six months ago," Governor Stephen Poloz told a news conference. Canada's central bank has walked a tightrope in recent months, seemingly happy to let dovish implications devalue the domestic currency in light of low inflation but wary of further inflating a frothy housing market. Poloz said one-off factors including an unseasonably cold start to the year had pushed core inflation higher, and newly minted Senior Deputy Governor Carolyn Wilkins added that the bank was trying to look past such factors in setting policy. "The bank will soon enter a communications challenge with core inflation momentum ratcheting higher," Mazen Issa, a senior strategist with TD Securities, wrote clients. While overall inflation hit the central bank's long-term 2 percent in April, core inflation was at 1.4 percent and Poloz pegged underlying inflation even lower, around 1.2 percent. This figure excluded effects from the exchange rates. "That's low and that leaves us vulnerable to a downside shock at any time," he said. The Bank of Canada has held interest rates since September 2010, and investors do not expect the next move, likely a hike, until well into 2015. Poloz and Wilkins spoke following the release of the bank's semiannual Financial System Review, which said household debt and overvalued housing remained the most important vulnerability, despite tighter regulation which curbed the risk of a housing crisis. "While the bank continues to see a constructive evolution in housing market imbalances and household credit, valuations are stretched, there is overbuilding in some parts of the housing market, and household indebtedness remains high," the bank said in a statement accompanying the 70-page report. It saw risks rising in China, which was "accumulating fragilities in the banking and shadow banking sectors, in local government finances, and in property markets." A potential series of defaults beginning with China's shadow banking sector could lead to a deep credit squeeze that cuts Chinese growth, a scenario that would hit Canada through lower commodity demand and possibly even a housing market correction, it said. Recent efforts by the European Central Bank to stave off deflation have helped lower the risk of crisis there, the bank said. It expressed concern about a stubbornly high Canadian consumer debt profile, signs of overbuilding of condominiums in key markets such as Toronto, and exposure to commodity prices and other external factors. The central bank defined vulnerabilities as ongoing conditions that could magnify the effect of a shock such as a sharp dip in house prices or a climb in U.S. interest rates. The central bank also flagged the risk associated with smaller Canadian institutions such as credit unions, which have been expanding their loan books both in real estate and with higher-risk segments of the population. (Editing by Matthew Lewis)