BoC Monetary Policy Monitor

HIGHLIGHTS

• The recession in Canada has developed some traction, as commodity prices remain in a funk, the U.S. is still deeply mired in recession, and the resulting economic slack has pushed inflation to the back burner. This has forced a scaling back of forecasts for the outlook.
• Against this backdrop, the case appears strong for a 50bps cut to the overnight rate, which will put it at 0.50%. We view the March 3rd meeting as the end of the easing cycle, however. Lowering rates any further would create too many technical difficulties to justify the offsetting benefit of easier policy.
• Not only does the economic data and central bank comments point to further easing, but recent statements from Bank of Canada officials suggest they are at least looking into alternative policy tools - just in case.

Heading into the March 3rd FAD, the economic data has confirmed the rather rapid deterioration in the Canadian economy, complete with evaporating price pressures. But in addition to the domestic retrenchment in activity, there has been even further evidence that the synchronized global contraction has found some traction. Moreover, financial conditions in both Canada and abroad remain under some degree of stress, and while there is not as much concern about the health of the domestic banking sector, the potential for spill over from the rest of the global rout in credit markets acts as a major millstone on the Canadian economy.

The rapid deterioration in the Canadian and global economies has forced the Bank of Canada to make substantial downward revisions to their forecast. GDP growth is projected to contract 1.2% in 2009 and to rebound by 3.8% in 2010. Much, of course, depends on how the global economy fares.

So in light of these factors, the case for one final 50bps rate cut by the Bank of Canada to leave the overnight rate at a historical low of 0.50% this Tuesday seems like a logical outcome. There is less of a case for the Bank to go further than that, given the technical difficulties imposed by a 0.00% overnight rate to any spread product and the fact that the Bank of Canada does not face quite the same set of dire conditions that have transpired in other G7 countries.

Spectacular Disappointments

That said, the last several months have not been easy. There has been a steady stream of disappointing data that confirms the economy quickly unravelled in the fourth quarter as not only the domestic drivers of growth contracted, but so too did the external drivers succumb to the recession in the U.S.

On the external front, the collapse in trade has put the once steady Canadian trade surplus into deficit for the first time since 1976. The interplay between the ongoing commodity prices unwind and the continued U.S. economic contraction both played a pivotal role. In December, Canada posted a trade deficit of $0.5 billion, which compares to a trade surplus of $1.2 billion in November. And naturally, the slump in exports was the primary culprit recently, as Canada's trade balance with the U.S. is now at its lowest level since 1998 at $3.8 billion. Exports to the United States dropped 10.0% in just one month, but the slide in imports indicted a similar deterioration in Canada's economy as imports from the U.S. fell 8.4% in December.

Though merchandise trade is only one part of the current account it is a rather large component and this suggests that the current account will be in a deficit position for the first time since the first quarter of 1991.

In conjunction with the recent federal budget released on January 27, which delivered a healthy dose of fiscal stimulus, it now looks like Canada can no longer claim the distinction of being the only G7 country with twin surplus. Running budget deficits is surely anathema to Canadians, but the severity of the global recessionary headwinds argues for countercyclical spending. As such, increased spending and tax cuts on a number of fronts led the Finance Department to project the budget deficit to widen to $33.7 billion in FY 2009-2010. The deficit for FY2010-2011 is expected to be $30 billion.

On the domestic front, the economy looks like it has also fallen out of bed. The labour market has softened quickly and measurably. In January, the Canadian economy lost 129K jobs, and in the three months to January, the economy lost a total of 212K jobs. With the employment landscape so fractured, the free fall in retail sales in December was impressive, though not surprising. Canadian retail sales tanked in December with a 5.4% M/M decline and excluding autos, retail sales were also weak with a decline of 3.2% M/M. The contraction in retailing activity speaks volumes about the mindset of the consumer, who is clearly loathe to take advantage of the steep discounting, as real retail sales also fell 4.1% M/M.

With slack building up at every turn, the fact that price pressures have been sliding quite significantly comes as an expected result. On the business side of the economy, capacity utilization rates are at historical lows and were 77.4% in the third quarter. Given that trade activity cratered in the fourth quarter, further slack will likely be recorded for the fourth quarter, and beyond.

On the consumer side, the growing slack has had a measurable impact on inflation trends. In January, headline inflation was just 1.1% Y/Y, which is the slowest annual pace of inflation since January 2007. Core inflation also softened suggesting that growing economic slack is putting downward pressure on goods and services. At 1.9% Y/Y, core inflation is now below the 2% target set out by the Bank of Canada.

Credit Markets Still Unhealthy

Canada is not immune from the 'adverse feedback loop' that is oft cited in the U.S. with regard to the interplay between credit markets and the real economy. Though credit conditions have improved since the worst of the turmoil in the fall of 2008, they are still under pressure. Perhaps the best example of the credit stress is best encompassed in TD's own Canadian Financial Stress Index (TDFSI), which has shown that the indicator remains in a “stressed” position.

As credit spreads still reflect a certain premium demanded to absorb the risk, the Bank of Canada has continued to ensure that liquidity is making its way into the pipes of the credit market as well as widen the scope of acceptable collateral for its Term PRA facilities. The Bank recently announced that it will now include some corporate bonds in another one of its facilities, with the expectation that it will encourage the use of the Term PRA program.

This is yet another positive step to mitigating the widening in spreads and alleviating funding costs for all economic players. But for now, the fact remains that there are still bottlenecks in credit markets and it will be some time before they resume full health.

Forewarned is Forearmed

Against this backdrop, recent comments from Bank of Canada Governor Carney certainly suggest that the Bank is leaving no stone unturned with regard to preparing for the worst. Carney's recent impromptu comments to the media suggest that the Bank is at least investigating alternative policy measures. He stated as much at a speech in December, but the fact that he reiterated the notion suggests that the Bank is using orthodox measures first, but keeping alternatives in their back pocket. So educating oneself in the ways in which these tools are implemented is a good thing.

The End is Near

The March FAD will be important in part because we think it will mark the end of the easing cycle for Canada. And there are a couple of reasons why the Bank will use this opportunity to deliver a 50bps rate cut to leave the overnight rate at 0.5% and then close the books on this easing cycle. There are three considerations in coming to this decision. First, why cut by 50bps if the Bank assumes a healthy rebound of 3.8% in 2010? The output gap, despite the rebound, is not expected to close until well after 2010. In addition, the rebound in 2010 assumes everything goes according to plan. But, while they are not stated, there are still significant downside risks. In light of these, a bit of insurance on monetary easing might be a good thing.

Could the Bank cut by a smaller amount? Possibly, but our reasoning is that doing an incremental “top up” at what is clearly the end of the easing cycle does not make sense. The trickle of easier rates would not have as much impact as one last 50bps rate cut. The current mix of loose fiscal and monetary policy should provide the necessary ground work to pave the way for a turnaround.

The second consideration is whether the Bank would take rates to zero percent eventually. While there is a convincing argument for a zero interest rate policy in other countries with more spectacular problems, the troubles in the Canadian economy are not so dire as to demand all the stops be pulled out especially if Canada is unlikely to truly escape the slowdown until the U.S. does too. The difficulties associated with a 0% overnight rate, in terms of pricing spread products outweigh the upside of even lower rates. Lastly, it creates difficulties for the Bank of Canada's role as an intermediary, as a zero overnight rate would create a disincentive for those willing to lend to the Bank as they would receive a negative interest rate for their funds.

But all this having being said, this is clearly a very fluid environment where conditions can change on a dime. As such, while we currently discount the view that overnight rates could go to zero, if the global recession deepens, one cannot completely rule out the possibility that the Bank could take rates lower than the 0.5% trough that we expect.

In the meantime, all eyes will be on the accompanying statement, which should reiterate the general economic outlook espoused at the last decision, but which could highlight downside risks, even as the statement is likely to shy away from further talk about “judging to what extent further monetary stimulus will be required.” The bigger question is whether the statement will hint at measures of unorthodox monetary policy and at present we are inclined to think not.

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.