Bank of Canada's Monetary Policy Report Fleshes in Forecast Details

The key take-aways from the Bank of Canada's Monetary Policy Report are:

The upgrade to Canada's growth forecast in 2011 to 2.9% from 2.4% reflects the lift from the stronger than expected the fourth quarter of 2010 growth plus a sharp upward revision to the second quarter of 2011's GDP growth forecast to 4.2% from 2.5%. For the rest of 2011, the Bank reduced its quarterly growth projections with second-quarter growth likely to be affected by supply disruptions spilling out from the Japanese disaster. The forecasted composition of growth in 2011 showed a modest increase in the contribution from consumption and business fixed investment. Net exports are still forecasted to add 0.1 percentage point (pp) to the economy's growth rate with housing and government spending reducing growth by 0.1 pp and 0.2 pp, respectively.

The improvement in the terms of trade is expected to boost household incomes and has supported an improvement in household net wealth. These improvements will be supportive for consumption going forward although the high level of indebtedness and stalling of house price appreciation will serve to mitigate some of this support.

The Canadian dollar is assumed to hold at US$1.03 up from the January assumption of US$1.00. The Bank stressed once again that the elevated level of the currency will result in the recovery in the export sector being more "subdued" compared to past periods in conjunction with Canada's "long-standing competitiveness challenges."

The Bank maintained the assumptions regarding potential growth that it published in October. The Bank estimates the economy's potential growth rate is 1.8% in 2011 and gradually increases to 2.1% in 2013. As of the first quarter of 2011, the Bank estimates the economy was operating at 0.9% below its capacity limit. Consistent with the updated growth rates for 2010, 2011, and 2012, the output gap will be closed by mid-2012, and correspondingly, the Bank expects both the headline and core inflation rates will be at the 2% target. This is a change from the January forecast that these inflation rates would return to the midpoint of the target range by the end of 2012, meaning that the window for the rate to hit the target is closing more rapidly than previously assumed.

The Bank cut its forecast for growth in 2012 to 2.6% from 2.8% in the January Monetary Policy Report. In 2013, the Bank expects the economy to grow at its potential rate of 2.1%. Consumer spending and business investment are forecasted to be the main drivers of growth in 2012 supplemented by an increase in the contribution from net exports. The Bank also indicated that the projections include "a gradual reduction in monetary stimulus."

The forecast for global growth was upped slightly in aggregated to 4.1% from 4.0%; although the forecast for the US was cut to 3.0% from 3.3%, and Japan's 2011 growth projection fell to 0.8% from 1.4%, therein reflecting the natural disasters that have recently visited that economy. Japanese growth is forecasted to rebound in 2012 to 2.6%. In the US, the cut to 2011 growth forecast reflects the increase in energy prices, which are expected to reduce the pace of consumption slightly. Higher commodity prices are expected to contribute to inflationary pressures globally, and global growth is forecasted to be maintained at around 4.0% for the next three years. In line with the movement in futures prices, the Bank upped its assumptions for the WTI prices for the forecast horizon and factored in expectations that non-energy commodity prices will remain elevated in 2011 and then decline as tight supply conditions diminish.

Risks to the outlook are roughly balanced according to the Monetary Policy Report with upside risks stemming from higher commodity prices boosting global inflation and firmer than expected domestic household spending due to "exceptionally stimulative financing conditions." Offsetting these risks are two downside risks with the strong Canadian dollar potentially creating "even greater" headwinds to the economy and high household debt levels presenting the risk of a sharp decline in household spending. Global risks are characterized as "elevated."

Our forecast calls for firmer growth than the Bank of Canada in both 2011 and 2012. RBC projects real GDP to increase by 3.2% and 3.1%, respectively, backed by solid labour market conditions and a gradual decline in the unemployment rate to 7.0%. Our forecast assumes that, even with an elevated currency (ending 2011 at C$0.95 and 2012 at C$1.02), the trade sector will provide a small add to the pace of growth as demand from the U.S. strengthens and imports increase at a slower pace than in 2010. Against this backdrop, economic conditions will require the Bank to reduce the amount of policy stimulus in order to contain upside risks to the inflation outlook. While today's Monetary Policy Report makes clear that the Bank remains comfortable with leaving the overnight rate at 1% for now, a further strengthening in the pace of growth during the months ahead will likely lead to a 25 basis point increase at the July 19 meeting and additional 25 basis point increases at each subsequent policy meeting this year resulting in the overnight rate ending 2011 at 2.0%.