Anna Asi, M.A.

Bank of Canada inching closer to a rate increase

As expected, the Bank of Canada maintained the policy rate at 1.00% today; however, the Bank assumed a more aggressive tone with respect to the outlook saying that "some of the considerable monetary policy stimulus currently in place will be withdrawn." This is a step up from the May statement, which projected that stimulus would be "eventually withdrawn." On the outlook for the global economy, the Bank reiterated that the expansion is proceeding as it expected in the April forecast. On global inflation, the Bank maintained that global pressures have broadened as strong growth in the emerging markets keeps upward pressure on commodity prices. The Bank expects that commodity prices will remain at elevated levels. Importantly, the Bank's forecast assumes that the European sovereign-debt crisis will be contained.

Recent data and the prospect of stronger growth going forward suggest that domestic conditions warrant higher interest rates. This is especially true in light of the stronger than expected inflation and employment numbers lately. The Bank's decision, however, to maintain the policy rate at 1.0% reflects lingering concerns about the pass through of external developments on Canada's economy. Uncertainty about U.S. and Eurozone fiscal policy, and the likelihood that there will be significant steps made toward the resolution of their fiscal challenges to placate financial markets is keeping alive the potential for global risk premia to rise. Even with its superior economic and fiscal fundamentals, it is unlikely that Canadian financial markets will be able to avoid coming under pressure should this occur.

While these external risks bear watching, the Bank still expects Canada's economy to post stronger growth in the second half of 2011, supported by very stimulative financial conditions. Similar to the Bank, our base case forecast is that the global economy will avoid a replay of 2008's financial market crisis and ensuing economic recession. After growing at a projected 2% annualized pace in the second quarter of 2011, we forecast the economy will accelerate with real GDP rising at a 4% average annualized pace in the second half of the year. Backing out the Bank's second-half 2011 growth forecast based on its 2011 projection that the economy will grow by 2.8% in 2011 suggests that our forecast is for Canada's economy to grow at a stronger clip in the final six months of the year. More details of the Bank's quarterly projections will be in tomorrow's Monetary Policy Report.

The Bank acknowledged that inflation has been running hotter than expected. The core rate is likely to average 1.7% in the second quarter of 2011 and the headline rate at 3.5%, with the June data to be reported on Friday sealing the second quarter of 2011. The Bank expects that headline inflation rate will hold above 3% in the near term, with core inflation now expected to "remain around 2% over the projection horizon." Persistently higher than expected services prices were attributed with the firmer than expected core rate. The Bank maintained its assessment that the headline rate will converge to the 2% target in the middle of next year. To that end, the Bank indicated that with the expansion expected to continue and excess slack absorbed, some of the current policy stimulus "will be withdrawn." Looking ahead, some of the key international issues are coming to a head in the weeks ahead and will give the Bank a clearer view about the global outlook when it meets again in September. Our expectation that the global economy will avoid another crisis sets the stage for Canada's domestic economy to reaccelerate and for the Bank to make good on its promise to withdraw "some of the considerable monetary policy stimulus currently in place" with the case for a September hike supported by today's statement.

Cat: RBC Report