Bank of Canada Maintains 0.25% Overnight Target While Noting Risks from Loonie Appreciation

HIGHLIGHTS

• Consistent with its conditional commitment to hold rates at current level until Q2/2010, the Bank maintained the 0.25% overnight target.
• Bank observed that economic data have been consistent with its forecast, reducing possibility of QE/CE, but expressed concern about the unprecedented appreciation of the Canadian dollar.

In its scheduled announcement, the Bank of Canada maintained the overnight target at 0.25%, consistent with its conditional commitment to maintain the rate at its current effective lower bound until at least Q2/2010. The announcement reiterated this commitment, and relayed that recent economic data was in-line with the outlook presented in the Bank's April Monetary Policy Report (MPR). The Bank set out its baseline scenario in the MPR and stipulated that any move to unconventional monetary policy would require a substantial deterioration from that baseline. Therefore, any move to quantitative or credit easing (QE/CE) appears increasingly unlikely in the nearterm, barring a substantial deterioration of conditions. Nonetheless, the Bank acknowledged the downside risks to core inflation, and reiterated that it "retains considerable flexibility in the conduct of monetary policy at low interest rates".

The Bank admitted the "major restructuring in a number of sectors" and acknowledged the considerable macroeconomic uncertainty. The turmoil in the auto sector was a prime factor in the cleaving of the Bank's forecast for 2009 potential growth from 2.4% to 1.2% in the April MPR. With the 5.4% annualized contraction during Q1/2009, the Bank faces a growing output gap between the economy's output and its potential. The output gap expanded to 3.5% for Q1/2009, and, based on the Bank's projections, the gap would widen to 4.8% by Q3/2009 before beginning to close. Such growing slack in the economy places downward pressure on prices.

The Bank noted positives in the improvement in financial conditions, a rally in commodity prices and some recovery in business confidence. The narrowing of spreads in credit markets reduces the possibility of direct CE intervention by the Bank, barring some significant worsening of financial conditions.

The Bank also expressed concern about the "unprecedentedly rapid rise" of the Canadian dollar. We regard this recent appreciation as driven by certain relative strengths in the Canadian economy and the commodity rally, but also owing to Stateside weakness and an unwinding of the "safe haven" flight that had previously buoyed the Greenback. That Canada hasn't joined the QE/CE club, with all the risks this uncertain path involves, increases the attractiveness of the currency. However, the pace of the gain - 10 cents in just over a month - is cause for concern. To the extent that the exchange rate is passed through to lower import prices, the higher Canadian dollar is a further downward pressure on inflation, but it also dampens the cost advantage of Canadian exports, a further near-term handicap to Canada's stumbling manufacturing sector.

With the terrific transparency that has characterized the Bank's communication, this announcement did not have much to add. The overall message remains one of prudence and steadiness. Data on economic and financial conditions will inform any future Bank response, and the statement appeared to reinforce the Bank's view of QE/CE only if necessary, and not necessarily QE/CE.

TD Bank Financial Group

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