Bank of Canada Holds the Line on Rates, Retains Neutral Stance

• Overnight rate unchanged at 3.0%
• Bank retains neutral stance

The Bank of Canada met market expectations today, keeping the target for the overnight rate steady at 3.0%. This is the second meeting that the Bank has stayed on the sidelines and the neutral tone of their accompanying communiqué did little to change expectations that this is where they intend to remain.

Three developments have been cited by the Bank as the most important to the outlook for inflation - weakened U.S. demand, turmoil in financial markets and rising commodity prices. While the first two developments have failed to show much improvement they have, according to the Bank, evolved largely in line with expectations laid out in April's Monetary Policy Report. The third development - rising commodity prices - has continued to surprise to the upside and is the primary reason that the Bank now judges the risks to the outlook for inflation to be roughly balanced.

Importantly, the Bank's statement also reflected their view that the Canadian economy is now believed to be in a state of excess supply, a necessary condition for moving inflation back in line with the Bank's target. Nonetheless, the continued upward surge in energy prices has led the Bank to raise their forecast for CPI inflation considerably - they now expect headline inflation to reach a high above 4.0% in the first quarter of 2009 (compared to a peak of 1.9% previously). Provided that energy prices stabilize, inflation is expected to move back towards the 2.0% mark by the second half of 2009.

On Thursday the Bank will release an update to its April Monetary Policy Report, giving more insight into their outlook for global growth and inflation. Since April, the Bank has seen first quarter Canadian growth surprise to the downside, contracting by 0.3% compared to an expected 1.0% increase. Consequently, the Bank has downgraded its forecast for Canadian growth to 1.0% in 2008 (from 1.4%) and in 2009 to 2.3% (from 2.4%).

With the Bank's downward revisions, their 2008 forecast has moved in-line with our own projections for the Canadian economy of 1.0%. However, we continue to deviate on the 2009 outlook, expecting only 1.8% growth. Signs have increased that in addition to the pressure from the external sector, the domestic economy is also beginning to cool. The boom in the housing market appears to have ended and while the headline numbers hide it, the labour market has also begun to show significant signs of weakness. As a result, slack will not be taken up in the domestic economy and the pressures to inflation outside of energy prices are likely to remain well contained. Moreover, like the Bank we believe the upside to energy price growth is limited and rather believe that lower energy prices by early 2009 remain the most likely scenario. For these reasons we continue to expect the Bank of Canada to remain on the sidelines, leaving interest rates unchanged at their current level until the second half of 2009. How these and recent external developments play into the Bank's measurement of the key risks to the inflation outlook will be the key things to watch for in the update to the MPR.

TD Bank Financial Group

The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.