Bank of Canada Marginally Downgrades Economic Outlook

Today's release of the Bank of Canada's Monetary Policy Report (MPR) gave us a glimpse into the economic forecast that supports the Bank's decision to raise interest rates for a second consecutive meeting on July 20th.

The Bank has marginally downgraded its economic forecast for Canadian real GDP to 3.5% in 2010 and 2.9% in 2011, from 3.7% and 3.1% in April's MPR. The downgrade largely reflects weaker global growth and consumer spending, which will partially be offset by stronger net exports and business investment. The economy is expected to grow at a pace close its potential rate in 2012 with real GDP growth of 2.2%.

On the international front, the Bank does not yet see the global economic recovery as "self-sustaining", and global economic growth will slow as government stimulus begins to unwind in the coming quarters. However, the Bank believes that the policy response to the European Sovereign debt crisis has mitigated some of the major risks outlined in April's MPR concerns over the fiscal situation in a number of European countries. Nonetheless, financial conditions have worsened since the April MPR, due to concerns over European debt and contagion and spillover effects.

The downgrade to Canadian consumer spending reflects a weaker outlook for income growth due to weaker global growth and commodity prices. The Bank still views that a significant amount of the strength in expenditures on housing and consumer related goods and services over the last two quarters was largely driven by households bringing forward demand to take advantage of record low interest rates and fiscal stimulus programs. As stimulus unwinds, household spending and investment is expected to cool. The Bank notes that the existing home market is already showing signs of moderation.

The better-than-expected performance of the Canadian economy over the last two quarters has meant that the slack accumulated over the downturn has been eaten-up at a much quicker pace. The output gap was deemed to be -1.5% in the second quarter from -2.3% in the first quarter and well below the - 3.7% gap in the depths of the recession. The output gap is now expected to close at the end of 2011, two-quarters later than was anticipated in April's MPR.

The Bank has slightly lowered its headline inflation expectations. The Bank expects headline inflation to average 2.2% for the second half of this year and the first half of 2011, largely owing to the implementation of a harmonized sales tax in Ontario and B.C.(it would be 1.8% without HST), before gradually falling back to 2.0% by the end of 2011. Core inflation is expected to average 1.8% over the rest of 2010 and 2011, returning back to 2.0% in 2012.

Key Implications

It is not a large surprise that the Bank of Canada has downgraded its economic forecast given the uncertainties around the global economic recovery and Canada's own economic prospects. Their 2010 forecast is now largely in-line with our estimate of 3.5%. We have been more pessimistic on Canada's growth potential in 2011, and even with the downgrade, the Bank of Canada remains more optimistic than our forecast for 2.5% growth in the year - but in-line with the consensus forecast of 2.8%.

Our more pessimistic outlook is driven by two main sources. First, we have a stronger Canadian dollar imbedded into our forecast. The Bank of Canada has already moved with two interest rate hikes, while we now believe the U.S. Federal Reserve will remain on hold until mid-2011. The interest rate differential between Canada and the U.S. will help propel the loonie to parity by the end of 2011. As such, the Bank of Canada has worked in a more positive impact from net trade. Second, we are a touch more pessimistic on the Canadian consumer.

Despite our slightly more pessimistic view, we still believe the Bank of Canada has plenty of room to continue hiking interest rates. The economic slowdown is coming on the back of two strong quarters of 5-6% annualized growth. The fast-and-furious recovery so far was enough to help absorb some of the slack that was accumulated over the economic downturn. Even as growth slows, the economic slack will continue to be eaten up - albeit at a more gradual pace. More importantly, with the robust recovery in employment, the unemployment rate has been on a downward trek since August 2009 - leaving less need for the extraordinary low level of interest rates.

With the Bank of Canada's estimate that the Canadian economy will return to full capacity by the end of 2011, we should expect the overnight rate to continue to head higher. We expect the Bank of Canada to continue with gradual 25 basis point rate hikes through the second half of 2010 and 2011, with two pauses - one at the end of each year. This would leave the overnight rate at 2.5% by the end of 2011, still low by historical standards.

Meanwhile, the Bank has stated that it will look past the transitory effects of harmonization in Ontario and B.C. on consumer prices. The Bank has a stronger headline inflation profile, but has worked in softer core consumer prices to reflect the pass-through of business cost savings associated with a tax credit now available to businesses.