Bank of Canada Defies Market Expectations, Stands Pat on Rates

The Bank of Canada defied market expectations and kept the overnight rate steady at 3% indicating that the balance of risks for the inflation outlook have shifted slightly to the upside and "that global growth has been stronger and commodity prices have been sharply higher than expected." The Bank cited an easing in the downside risks to the economic outlook as supporting their decision despite the modest, and unexpected, 0.3% decline in first-quarter GDP.

After cutting the policy rate by 150 basis points, the Bank "now judges that the current stance of monetary policy is appropriately accommodative to bring aggregate demand and supply into balance and to achieve the 2 per cent inflation target."

Even though Canada's economy posted weaker-than-expected economic activity in the first quarter, tentative signs that the U.S. economy will avoid recession and that financial markets, while skittish, no longer are priced for recession, have dampened some of the downside risks to Canada's economic outlook. Early in the second quarter, inflation was broadly tracking the Bank of Canada's forecast with the all-items rate running bang on the Bank's 1.7% expected second-quarter rate, although, at 1.5%, the core measure was running slightly faster than the Bank's second-quarter projection of 1.3%.

In today's statement, the Bank showed heightened concern about the inflation outlook, stating that if the recent spurt in energy prices persists "total CPI inflation will rise above 3 per cent later this year." Policymakers still expect the core inflation rate to remain below 2% through 2009 as the excess capacity in the economy continues to grow.

The tone of today's statement makes clear that the Bank of Canada has joined the ranks of other central banks who are fearful that inflation pressures are brewing and will bolster inflation expectations going forward. On growth, the Bank seems to be more confident that the degree of monetary policy stimulus is adequate to lift the economy from the decline evident in the first quarter. RBC forecasts a mild bounce-back in GDP growth in the second quarter, with the economy growing by 2.5% in the second half of the year.

We agree with the Bank's view that the headline inflation rate is likely to be higher than in their April forecast with energy prices having moved well above their baseline projection set in April. Our forecast assumes that the core rate will also likely run slightly hotter than the Bank expected in April. Still, Canada's inflation rates remain the lowest among industrialized countries except in Japan. The Bank of Canada is unlikely to switch to a tightening policy stance in the near-term, especially with the economy growing at a slower-than-potential rate this year. The Bank's concluding statement that "there continue to be important downside and upside risks to inflation in Canada, which the Bank will monitor closely" implies no policy action anytime soon.

RBC Financial Group
http://www.rbc.com

The statements and statistics contained herein have been prepared by the Economics Department of RBC Financial Group based on information from sources considered to be reliable. We make no representation or warranty, express or implied, as to its accuracy or completeness. This report is for the information of investors and business persons and does not constitute an offer to sell or a solicitation to buy securities.