Canadian Monetary Policy Report

July 20, 2011

The 38-page quarterly Monetary Policy Report retains a mid-2012 target date for the restoration of full capacity in Canada, presents only marginally modified price and growth projections, declares medium-term price expectations to be firmly anchored around the Bank of Canada’s 2.0% target, and argues that it would be appropriate for the central bank interest rate to return to its long-term level sometime after, rather than at the same time, as the attainment of full capacity.

Canadian real GDP expanded 1.5% last quarter compared to 2.0%, which had been assumed in the prior April report, but is now projected to rise 2.8% in 2H11, an upward revision from 2.7% assumed in April.  Projected growth of 2.6% in 2012 and 2.1% are the same as those made three months ago.  The composition of growth shows a slower transformation away from consumption and government spending in favor of net exports and investment than envisioned previously.  The new projected trajectory of total CPI inflation traces on-year readings of 2.8% this quarter, 2.6% in 4Q11, 2.3% in 1Q12, 1.9% in 2Q12 and 2.0% thereafter.  Core inflation is put at 1.9% in 3Q11, 2.0% in 4Q, 2.1% in 1Q12 and then flat-lines at the 2.0% target for the remainder of the forecast horizon.  Commodity prices remain historically high, while wages are rising only modestly.

The conventionally measured output gap, the spread between actual GDP and its hypothetical level if all productive resources were utilized, was 0.7% in 2Q11 after 0.9% in 1Q11, and 1.75% in both 3Q10 and 4Q10.  Taking other measures of economic slack into account modifies the estimated output gap to be slightly less than 1.0% versus about 1.0% in 1Q.  Policymakers, as they did in April, still believe that full capacity will be reached about mid-2012, a year from now.  With a price target of 2.0% and an assumed non-inflationary rate of real economic growth of 2.1%, Canada’s central bank rate of 1.0% currently lies 300 basis points below its ideal long-term level.

A strict Taylor Rule application would suggest that the target interest rate ought to be lifted at a pace of 50-75 basis points per quarter over the coming year.  In these days of heightened risk aversion, officials probably felt some urgency to dissuade investors from anticipating such an aggressive path.  Accordingly, a new rule of policy guidance was introduced under which a 4% central bank rate would not be reached until the full effect of present headwinds has dissipated.  The practical significance of this new theory is to allow the Bank of Canada and other like-minded central banks to adopt a more gradual path of interest rate increases.  In Canada’s case, the rate target probably will climb 25-50 basis points per quarter.

In the long run, once the effects of all current and past economic headwinds and tailwinds have fully dissipated, CPI inflation can be expected to equal (and remain at) the 2 per cent target, output can be expected to equal (and remain at) the economy‚Äôs production potential, and the target  overnight rate can be expected to equal (and remain at) its long-run level.

Over the shorter run, monetary policy can be used to offset the expected ongoing impact of economic headwinds or tailwinds on inflation and output. In these cases, the policy rate will need to deviate from its long-run level to provide the stimulus or restraint necessary to offset these headwinds or tailwinds and return inflation to the target.

The central bank’s review contains other nuggets of useful information.  Here are some.

  • Canadian officials are assuming that U.S. fiscal consolidation exerts a drag of 1.0 percentage points on GDP growth next year to 3.2% and of 1.7 ppts in 2013 to 3.3%. 
  • The two-year 2012-13 combined GDP growth of 6.0% in Japan and 6.6% in the United States are assumed to be almost twice as much as the 3.5% advance assumed in the euro area but fall far short of projected 17.4% two-year growth in China.
  • Monetary conditions in emerging market economies like China remain “exceptionally stimulative.”
  • One major economic headwind is the persistent strength of the Canadian dollar, and another is the atypically weak U.S. economic recovery and the fiscal restraint that will promote a continuing sub-normal business recovery in Canada’s dominant trading partner.
  • Japan’s recession has bottomed.
  • Canadian household and business credit are expanding close their historical averages, suggesting comfortable financial conditions in spite of the turbulence in other regions.

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

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