Bank of Canada's July Monetary Policy Report Update

• U.S. & Canadian economic growth unfolding largely as forecast in April
• Commodity prices outpacing expectations, implying near-term inflation spike
• BoC remains more optimistic on U.S. than TD Economics

After having eased the overnight interest rate by 150 basis points since December 2007 and surprisingly shifting into neutral at 3.00% in June, Tuesday’s decision by the Bank of Canada (BoC) to stand-pat once again came as no surprise. In a context where the Canadian economy was showing clear signs of strain but only benign inflation, markets had anticipated a further 25 basis points cut in June. Since then, Canadian inflation, while still contained in June, has shown signs of catching up to other developed economies’ elevated (3-5%) headline inflation rates. Moreover, inflation expectations are on the rise due to a surge in energy prices. Breakeven inflation, the market spread between conventional and real-return bonds, which had been mostly declining since mid-2006, sat at 2.6% in June. The BoC’s latest Business Outlook Survey shows nearly 9 our of 10 firms expecting, over the next two years, inflation to be 2% or more while over a third expect it to be 3% or more. With hindsight, the move away from a downshifting of rates to a neutral gear seems justified, necessary even.

Peering into today’s Monetary Policy Report Update, the BoC emphasized three shocks hitting the Canadian economy all at once: protracted weakness in the U.S. economy, financial market turmoil, and surging commodity prices. The BoC views the first two as unfolding largely in line with its April MPR forecast. It is commodity prices that have caught them off-guard, and admittedly most others, including ourselves. Oil prices, and most importantly its futures, stand near elevated spot prices and reflect a view that no relief is in sight. On the flip side, they also reflect the view that we are not likely facing the same upside in oil prices going forward. This last point suggests we will simply observe a temporary spike in inflation which would not require any tightening of policy. The BoC expects headline inflation to peak above 4% in Q1.09, only to dip back down to the 2% target H2.09. Core inflation is expected to edge up gradually but stay well contained, reaching 2% by the H2.09.

The main upside risks to this outlook are that oil prices could keep trekking upwards unabated and/or that firms pass on their input cost inflation to final goods to a greater extent. As for downside risks, we remain more pessimistic than the BoC on the U.S. growth outlook for 2009, which results in both U.S. and Canadian real GDP growth forecasts that are a half-percentage point lower than theirs. In his semiannual MPR on Tuesday, U.S. Fed Chairman Bernanke abandoned his previous assessment that threats to growth were “diminished somewhat”, instead emphasizing “significant downside risks to the outlook for growth”. The temporary boost from tax rebates is already showing signs of fading after having not fully delivered as anticipated. The likelihood remains high that growth could disappoint while energy prices or their trickle-down to final goods prices will be higher yet. If these risks were to materialize and ‘stagflation-lite’ turn into outright stagflation, the BoC would send a shot across the bow (tweaking rates upwards) as a reminder it has not lost sight of its mandate. We’re not there yet, and our most likely scenario has the BoC on the sidelines until the second half of 2009.

TD Bank Financial Group

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