BoC Monetary Policy Monitor

HIGHLIGHTS

• Recent data suggest that the Canadian economy continues to slide into recession. Moreover, slumping commodity prices and growing economic slack will keep downward pressure on inflation.
• Globally, economic conditions continue to deteriorate, and the Fed set a precedent by lowering the fed funds rate to a new historical low. Against this backdrop, the Bank of Canada has a strong case to cut rates on January 20.
• We therefore look for the Bank of Canada to cut rates by 50 basis points, leaving the overnight rate at 1.0%.
• The communiqué is unlikely to depart significantly from the December statement, though the Bank might scale back their rhetoric on further rate cuts. That said, the tone will remain broadly dovish.

About the only major change since the Bank of Canada last met on December 9 is the pace of deterioration in the economic activity. The Bank of Canada lopped off 75bps from the overnight rate, putting it at 1.50%. And even at this new historical low in official rates, there is still a solid case for more monetary stimulus.

The economic data in Canada has categorically deteriorated further, and against this backdrop much of the world is in recession, which suggests that the turnaround will be slow. Moreover, there have been signs—both qualitative and quantitative—that inflation is on a downtrend. Finally, credit conditions remain in frail health, suggesting ongoing downward pressure on the economy. The combination of these factors suggests that the Bank of Canada has scope to address the very real problems in the Canadian economy. As such, we continue to call for a 50 basis point rate cut by the Bank of Canada next week, which will leave the overnight rate at 1.0%.

The Wobbly Legs on the Table

The Canadian economy has been among the last of the G7 countries to buckle, thanks to the resilience of its domestic fundamentals. However the high frequency data continues to suggest that the resilience gave way to sickness late in the fourth quarter. Housing, consumption and employment have all posted lacklustre to outright disappointing numbers recently.

The Canadian economy lost 70K jobs in November and another 34.4K in December. This has created a great deal of uncertainty about future income growth. Moreover the housing market remains on a slippery slope. House prices are up only a paltry 0.7% Y/Y in December and while the correction is not going to be as severe as in the U.S., it is not going to go unnoticed. So the interplay of uncertainty over future income growth, plus declining home values forced consumers into a belt tightening mode.

But the main drag on the economy is via trade and in that regard, Canada's exposure to trade is a blessing in good times and a curse in bad. Canada's export sector has already come under pressure and will continue to do so from three main sources. First, soft commodity prices will pose a key drag on incomes. Second, Canada's status of having one of the highest exposures to exports in the developed world means that it is always leveraged to global growth trends as well as exchange rates. Third, the lion's share of those exports are destined to the U.S., which is currently toughing it out though the worse recession since the early 1980's.

The recent survey data from the Bank of Canada paints an equally miserable picture. The fourth quarter Business Outlook survey showed that overall sentiment for business activity has deteriorated quite sharply, as the effects of the global financial crisis and recessions across the world grip markets. The survey stated that almost all indicators are the lowest since the survey began in 1997.

One key metric in the survey was the balance of opinion on employment prospects, which turned negative for the first time in the survey's history. As such, employers' expectations for hiring look bleak and it seems like the Canada labour market is poised for further contraction. We believe a quarter million jobs will be lopped off payrolls this year.

Inflation Nearly gets a D

Though currently a bit elevated, inflation is unlikely to fundamentally shift the Bank of Canada's thinking on easing. The Bank has made it clear that it will focus on alleviating the strains on the economy due to the global economic recession and ongoing turmoil in the credit markets. And although recent inflation data for November remained hotter than expected, as headline inflation was 2.0% Y/Y and core inflation was 2.4% Y/Y. But inflation is poised to soften as growing spare capacity and soft commodity prices limit inflationary trends.

This theme is pretty much priced into the markets. In the Bank of Canada's Business Outlook Survey, the balance of opinion on inflation trends showed a massive retrenchment in expectations. In the survey, 30% of respondents expect the annual rate of price inflation to be below 1.0% over the next few years, and nearly three quarters of respondents expect inflation to be below 2.0%. Indeed, with mounting spare capacity, inflation trends may just narrowly avert earning a ‘D' to create deflation.

Financial Markets Still in a Dither

The proof is in the pudding as they say, and the evidence from Canadian credit spreads suggests that there is still a good degree of uncertainty about the quality of the underlying receivables. And with the growing recession, credit quality remains at risk. This uncertainty remains a weight on the entire yield curve from commercial paper, to 5-yr corporate bonds and to slightly longer tenures.

In terms of business reaction to the uncertainty, the fall out has been measurable. According to the Bank of Canada's Senior Loan Officers Survey (SLOS) there was a broad based restriction in lending conditions, as both pricing and non-pricing aspects of business lending tightened. The lack of any meaningful improvement in credit conditions argues for the need for further stimulus to unwind some of this tightening.

In Word and in Deed

In a key speech at the end of 2008, Governor Carney noted that 2009 is shaping up to be a rocky ride. He advocated taking a macroprudential approach to the global financial crisis, but urged markets to “focus on the forest, not the trees.” That is to say, that while the near term profile looks quite anaemic, the underlying longer term fundamentals still look favourable, despite the likelihood of the federal budget slipping into a deficit position for the first time in a decade.

However, Carney admitted that the Bank was looking into alternative policy tools. Although the Bank is simply exploring the implications of alternative policy measures on financial markets, it serves as a useful exercise in this uncertain environment. In this regard, forewarned is forearmed.

Comments by Deputy Governor Duguay in early January reiterated the view that the Canadian economy is slipping saying that “our economy is now in recession as a result of the weakness in global economic activity engendered by the financial crisis.” As such, it seems that all the rhetoric out of the Bank points to one thing and one thing only—further easing.

How Much More?

While a 75bps rate would not raise too many eyebrows among the global central banking cognoscenti, especially given the size of other central banks' rate cuts, the market appears to have mostly priced in a 50bps rate cut for January 20. To us, that seems the most reasonable plan of attack for a couple of reasons. First, while economic conditions have deteriorated, hey have not done so at as pace that suggests a free fall in economy activity, which would otherwise argue for a more aggressive move. Second, despite the admission that it is looking into alternative policy tools, we think the Bank will try to sidestep any money market implications and avoid the zero bound on the overnight rate. Thus, if the Bank were to cut 75bps leaving the overnight rate at 75bps, if the next move was a 50bps rate cut, there would be very little room for manoeuvring. This argues for two more 50bps rate cuts, which is our core view and would ultimately take the overnight rate down to 50bps.

Will the Doves Still Be Circling After January?

Based on the expectation that the Bank will ease rates by another 50 bps next week, leaving the overnight rate at 1.0%, the statement takes on a bit more prominent role as there is less room for traditional monetary policy measures. On that front, the Bank will need to strike a delicate balance between signalling further cuts and sounding too dovish and allowing the market to get ahead of itself. The statement will undoubtedly maintain the rather dour paragraph describing the economic outlook and the lower profile for inflation.

The question is whether it will retain the statement that “the Bank will monitor carefully economic and financial developments in judging to what extent further monetary stimulus will be required to achieve the 2 per cent inflation target.” The Bank may be reluctant to commit to a course of action given that there is little room to manoeuvre when the overnight rate is 1.0%. Instead, the Bank might be inclined to rephrase that portion of the statement to be a little more noncommittal.

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.