Bank of Canada Unveils a More Subdued Inflation Forecast

October 20, 2010

The Bank of Canada’s October Monetary Policy Report elaborates on the assertion in yesterday’s interest rate statement that the global and Canadian recoveries have entered a “new phase” with more gradual rates of growth than envisaged three months ago.  The evolution of projected Canadian GDP growth over the past four quarterly policy reports is as follows:

Forecast from 2010-f 2011-f 2012-f
October 2010 3.0% 2.3% 2.6%
July 2010 3.5% 2.9% 2.2%
April 2010 3.7% 3.1% 1.9%
January 2010 2.9% 3.5%  

Compared to forecasts released in July, projected growth in the second half of 2010 has been revised downward to 2.1% from 3.0%, and that for the first half of 2011 was modified to 2.4% from 3.0% envisaged before.  As a result, GDP in Canada over the coming twelve months will climb 2.3% versus 3.0% assumed three months ago.  The main cause of this revision is that the Bank of Canada sees U.S. growth in 2011 of just 2.3% instead of 3.0% assumed before.  Augmented by the drag of a pricier Canadian dollar, net exports are expected to augment Canadian GDP by just 0.3 percentage points next year instead of 0.8 percentage points as assumed in July’s publication.  A slower profile of household spending growth was also unveiled, reflecting slow growth in incomes.  Finally, real Canadian growth in the second quarter of 2010, 2.0% annualized, was a percentage point less than bank officials had expected.

As a result of the above changes, Canada’s estimated output gap — that is, how far below productive capacity the economy is operating — widened by a quarter percentage point between June and September 2010 to 1.75%, and the timing of the eventual return to full capacity usage has been pushed back to the final quarter of 2012 from estimates of 4Q11 made in the July report and 2Q11 assumed only six months ago.  This is a huge forecast change in the space of a half year, giving officials much more lead time before monetary policy needs to be restored to a neutral stance that neither promotes nor retards economic growth.

These changes also modify the future path of projected CPI inflation in a significant way.  The Bank of Canada uses a CPI target of 2.0% monitors the core price index for short-term operational guidance.  In the July report, total and core CPI in the second half of 2010 were projected at 1.8% and 2.1%, respectively, and they were expected to converge on the 2.0% target at the cusp between 2011 and 2012.  Inflation in the second half of 2010 is now seen being centered on 1.6% for core, which then drops to a cyclical trough of 1.5% in early 2011.  2% core inflation will not be restored until the final quarter of 2012, and the same is true for the total CPI index.  This more subdued inflation forecast reflects greater excess supply conditions for a longer period of time, as well as a a pronounced decline in the growth of unit labor costs from 4.2% in the year to 1Q09 to 0.1% in the year to 2Q10.  According to the usual gauges that officials use, expected inflation remains well anchored at the 2.0% target, but considerable monetary stimulus now in place needs to be retained in order to ensure that target is met and not under-shot.

Risks to the new inflation forecasts are considered roughly balanced.  Among mentioned downside risks is the following timely citation in light of the present chatter about possible currency wars:

Heightened foreign exchange market tensions could inhibit necessary global adjustment and put additional pressure on freely floating currencies.

The Bank of Canada left its key interest rate at 1.0% this week, after three hikes of 25 bps each since early June.  At 1.0%, the target is as high as the ECB refinancing rate for the first time since the first quarter of 2008.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.



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