BoC Monetary Policy Report - Quantitative Easing if Necessary but Not Necessarily Quantitative Easing

• BoC dramatically cuts economic growth forecasts
• Inflation to remain below target until Q3 2011
• No direct commitment to Quantitative Easing

Reading through the past several Monetary Policy Reports (MPR) of the Bank of Canada (BoC) a common theme has emerged: “economic conditions have continued to deteriorate requiring more aggressive monetary action.” Like other forecasters, the BoC once again significantly downgraded their economic growth outlook, now expecting an outright decline in global economic activity in 2009 (to -0.8% from 1.1% previously) and a more muted recovery in 2010 (2.2% from 3.7% previously). The synchronicity of the global economic downturn has also worsened the prospects for Canada's economy. In the near-term the substantial decline in sales in the final quarter of last year will result in a significant cut in production in the first quarter in order to draw down inventories. As a result, the MPR sees first quarter growth in Canada reduced to a stunning -7.3% (from -4.8% in January). In the medium-term a more protracted global slump and slower action to recapitalize the financial system is expected to result in a deeper decline in Canadian economic activity and a much slower pace of recovery. All told, the Canadian economy is expected to contract by 3.0% in 2009 (down from -1.2%) and improve to +2.5% in 2010 (from +3.8% previously).

Up until now, the BoC has responded to the worsened economic environment exactly as they would be expected to - by lowering short-term interest rates. But, after having reduced their overnight rate by a cumulative 4.25 percentage points, their traditional lever now sits at 0.25%, its “effective lower bound.” As promised, this MPR contained guidance on how the Bank plans to conduct monetary policy when their traditional tool has been removed. While many were looking for some meat on a specific plan for Quantitative Easing (QE) and/or Credit Easing (CE) - either by buying longer-term government bonds or trying their hands in other credit markets, the BoC chose to extend a more cautious approach. As the Bank recognizes, the risks associated with non-traditional monetary policy can not be discounted. And consistent with their mandate of maintaining low and stable inflation, the Bank has elected to describe what QE/CE would imply without making an outright commitment to using it.

Instead, the Bank will attempt to leverage their reputation as one of the more transparent Central Banks around. They will add more detail to their outlook for inflation by including confidence bands around their forecasts and will continue to state on a regular basis just how long they intend to keep short term interest rates at their current level. If the Bank decides to actively engage in QE/CE they would judge its effectiveness by watching movements in the yield curve and the improvement in financial conditions, as well as communicate their intentions at separate announcements from their fixed announcement dates.

While it may not attract the headlines that QE does, the MPR also contained important information on the Bank of Canada's views on the potential growth rate of the Canadian economy. As the default setting for Canadian economic growth, the Bank's assessment of potential growth is a key driver to the outlook for inflation. If growth is above potential, inflation pressures increase, if below disinflation becomes a concern. Importantly, the Bank cut its estimate for Canadian potential growth in half in 2009 to 1.2% (from 2.4%), and to 1.5% in 2010 and 1.9% in 2011 (from a previous estimates of 2.5% in both years). A lower potential growth rate means that an economic recovery does not have to be as strong in order to move from a disinflationary environment of excess supply to an inflationary environment of excess demand. This also helps to explain why the Bank sees inflation returning to target by 2011. Finally in keeping with the Bank's motto of increasing transparency, it also gives market watchers guidance on the rate of growth we would need to see in order for the Bank to start removing monetary stimulus.

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.