Bank of Canada Monetary Policy Report: Highlights and Inferences

April 13, 2011

The main finding of the new central bank quarterly report is the re-estimation of excess supply in the Canadian economy.  Officials believe that actual real GDP in the first quarter of 2011 was about 1.0% lower than potential level of GDP if the economy had been operating at full capacity.  The new forecast signifies less slack than had been assumed.  In earlier central bank reports issued in October 2010 and January 2011, the so-called output gap in both the third and fourth quarters had been projected at 1.75%.  This modification is the basis for moving up the predicted return to full capacity to the middle of next year from end-2012 assumed previously.

Some assumptions have been changed, such as those for future commodity prices and for Japanese growth this year and next.  The average West Texas Intermediate crude oil price over the coming seven quarters was bumped up by around 14%.  Japanese growth, which approached 4% last year, is seen slowing to just 0.8% in 2011.  Growth assumptions for other economies were revised higher, such that world GDP is assumed to advance 4.1% this year and 3.9% in both 2012 and 2013.  These are similar to what the January Monetary Policy Report had assumed.

Nonetheless, net exports will be providing less stimulus than previously assumed because of the effects of a stronger Canadian dollar exchange rate.  Net foreign demand will account for just 0.1 percentage points (ppts) of GDP growth in 2011, 0.5 ppts in 2012 and 0.2 ppts in 2013.  The forward thrust from final domestic demand of 2.9 ppts this year and 1.9 ppts in 2012 and 2013 will be about evenly split between personal consumption and business investment.  Residential investment contributes nothing on balance over the projection horizon, and government spending exerts a sharper drag of 0.2 ppts this year and 0.6 ppts in 2012 than had been assumed before.  It turns out that more of the fiscal stimulus was delivered in 2010 and that 2011 and 2012 will be feeling the impact of the removal of that stimulus more intensively.  All in all, real GDP grows 2.9% this year compared to an unrevised estimated gain in potential GDP of 1.8%.  Over the three-fourths of 2011 that remain, about two-thirds of a percentage point of excess capacity will disappear, and the rest will be whittled down in the first half of 2012 when real annualized GDP growth of 2.6% surpasses potential GDP of 2.0%.

The projected path of inflation represents not so much a forecast as an indication of policy intention.  At the moment, total CPI inflation (2.4% last quarter) exceeds the 2.0% medium-term target, and core inflation (1.2%) lies below the Bank’s goal.  Total inflation has been bolstered by temporary factors, while core inflation will naturally climb as economic slack lessens.  Central bank authorities for years have used a model that conceptualizes the direction of inflation — that is whether such is decelerating or accelerating — as a function of excess supply or excess demand in the economy.  Today’s report projects total inflation from above 2% and core inflation from below converging upon the medium-term goal and each reaching such during the second quarter of 2012.  There’s a very good reason that they selected that quarter, because that is exactly when they expect Canada’s economy to return to full capacity.  The inflation forecast then flat-lines along the 2.0% target for every remaining quarter of the projected horizon through the end of 2013.

The forecast tell markets that policy will be normalized progressively so that a neutral stance is in place in time to prevent inflation from accelerating above 2.0% in the out-years of the forecast.  Right now, the overnight interest rate is at 1.0%.  That’s above the 0.25% cyclical low prior to June 2010, but it remains well below a semblance of neutrality.  Cyclical peaks of 5.75% in 2000 and 4.5% in 2007 were clearly in restrictive territory.  The average target rate in 2000-2007 fell between 3.0% and 3.5%.  Should Canadian dollar strength persist, one might even argue that a 2-handle could connote neutrality, but that still would leave officials with 150 basis points or a bit more more of tightening over the coming year. 

The baseline outlook in the April 2011 Monetary Policy Outlook could also be blown off course.  It would be very unusual if it weren’t modified a little.  New forecasts are worked up by the central bank on a quarterly basis, and it’s not uncommon to see something tweaked with each issue.  At this point, officials feel that risks to their inflation forecast are equally balanced between it being too high or too low.  The latest full report and a four-page executive summary can be be found by clicking on the appropriate links.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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