Bank of Canada Catches Markets off Guard by Leaving Rates Unchanged

• Bank of Canada does not cut rates
• Overnight rate held at 3.00%
• Central bank expresses concern over inflation risks

The Bank of Canada proved today that it has a mind of its own. Although financial market participants unanimously expected a quarter point cut in the overnight rate, the Bank decided not to comply. The overnight rate was left unchanged at 3.00%. In addition, there is no longer a reference in the communication of "further monetary stimulus", which was instead replaced with the view that "the current stance of monetary policy is appropriately accommodative". In other words, the central bank is officially on hold with interest rates. Economic conditions would need to deteriorate beyond their expectation or inflation would need to heat up in order to prompt a monetary response.

The decision to leave rates unchanged was embedded in the belief that economic developments are unfolding broadly in line with their expectations set out in the April Monetary Policy Report (MPR). However, there has been one new development since then. The central bank joined the chorus of international voices by expressing slightly more concern over inflation prospects by noting that "the balance of risks to the Bank’s April projection for inflation in Canada has shifted slightly to the upside". Higher-than-expected commodity prices and global growth are to credit for this statement.

The view of higher inflation risks may seem at odds given the recent weak performance of the economy, which contracted by an annualized 0.3% in the first quarter, well below their expectations for a 1.0% gain. This should automatically result in a greater build-up of economic slack than the Bank had assumed in the April MPR. However, the Bank also indicated in this morning’s communication that there is a risk that potential economic growth will be weaker then they initially believed. If potential growth turns out to be indeed lower, then it is possible to have slower economic growth without economic slack building beyond their current expectations. Thus, slower growth would not necessarily dampen inflation.

The Bank of Canada ended their communication to markets by noting that they will continue to monitor the upside and downside risks to inflation. From our perspective, the upside risks to inflation come from two sources: a waning dampening influence on prices from a high Canadian dollar and/or a broad pass-through of energy costs to consumer prices. The downside risks to inflation are that the Bank is being overly optimistic on Canada’s economic growth prospects. We believe there is particular merit to the latter. According to the April MPR, the central bank believes economic growth will strengthen to a 2.4% pace in 2009, and a further 3.3% pace in 2010. However, we believe real GDP growth is more likely to top only 1.8% in 2009, and this should help keep inflation at bay beyond the Bank’s expectation.

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.