RGE Wednesday Note: A Balancing Act for the Bank of Canada

The Bank of Canada (BoC) raised its overnight target rate to 1% at its September 8 meeting, in line with the expectations we put forth in last week’s North America Focus. What was unexpected was the hawkish tone of the central bank’s statement announcing the decision, which glossed over glaring signs of slowing domestic growth.

The statement boosted market expectations of another hike, but we think that as the bank’s focus shifts to the “unusually uncertain” international economic outlook, further tightening will become increasingly unlikely. In our latest Focus report, available exclusively to RGE clients, we dissect the BoC statement for clues on its next move.

In the statement, BoC Governor Mark Carney et al stressed the instrumental role of consumption and investment in driving output growth and devoted less attention to the fact that Q2 GDP growth of 2% fell far short of the bank’s 3% projection in July. Reading between the lines, we see the BoC penciling in relatively strong domestic growth, likely higher than RGE’s 1.5-2% forecast for H2 2010. (Keep an eye out for next week’s more detailed update to our 2010 Outlook.)

Last week, we detailed the slowdown in domestic final demand, including consumer spending, and noted our skepticism that strong investment will persist after inventory restocking ebbs. A strong loonie will keep goods imports attractive, but it remains to be seen if final demand will hold up. Now that tax incentives have waned and consumer debt levels have risen, we expect consumption growth to cool. Underscoring this hurdle, last week’s data showed a record trade deficit of C$2.7 billion in July. Plus, a cooling housing market, showcased in last week’s data, implies that residential investment will no longer drive growth. With resale activity having dwindled by 30% in the past six months, moderation in residential construction is sure to follow.

The notable easing in the components of aggregate demand will limit further gains in the Canadian labor market. According to the employment data for August released last week, growth in full-time employment has lagged behind that in part-time jobs, and private sector jobs have fallen for two consecutive months.

Less need for balance sheet repair should allow Canada to continue to outgrow most of the G7, but it cannot decouple from U.S. growth, in part because of its export reliance (as most of Canada’s resource exports are U.S.-bound).

These dynamics and the moderate core inflation rate warrant the BoC maintaining the current, accommodative interest rates for the rest of 2010, despite its concerns about excessive debt practices (evident in the statement). A pause also would allow the bank to assess the impact of the 75 basis points of rate increases it has implemented since June. Moreover, somewhat easier monetary policy would offset the moderate tightening of fiscal policy that provincial governments are spearheading. Given weakening demand south of the border, falling commodity prices and the deceleration of national output growth, the central bank will face the challenge of supporting economic growth without encouraging further excesses in the housing market. This balancing act may prove quite difficult.


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