Bank of Canada to Cut Key Interest Rate Tomorrow

June 9, 2008

Similar to the FOMC, policymakers at the Bank of Canada schedule eight meetings per year to review economic conditions and set the overnight interest rate target. Under emergency conditions, the rate can be changed between meetings, but that happens very seldomly. The key rate was reduced at each of the last four meetings — by 25 bps each on December 4th and January 22nd and by 50 bps each on March 4th and April 22nd. I share the market consensus view that looks for a 25-basis point cut to 2.75% tomorrow. And also as in the United States, this move will be the last reduction for now. The statement from April 22nd warned that “some further monetary stimulus will likely be required to achieve the inflation target over the medium term.” Enough indications of economic weakness emerged subsequently to warrant acting on that possibility one more time.

Real GDP fell 0.3% at a seasonally adjusted annualized rate in 1Q following growth of just 0.8% saar in 4Q07. Growth in jobs slowed in 2Q08 with gains of 19.2K in April and 8.4K in May. Only one of the last five reported months to March showed a rise in monthly GDP. Retail sales dropped in five of the last six reported months. Manufacturing sales and orders slumped between July and March by 5.6% and 4.7%.

Inflation had been better behaved in Canada than most other economies. During the six months to April, the CPI advanced 2.2% saar compared to a 4.5% annualized climb in U.S. consumer prices. But price strains are nevertheless intensifying in Canada. A 0.8% unadjusted on-month CPI increase in April was the largest gain in 11 months, and that translated into the biggest seasonally adjusted increase since November. Producer prices soared 16.4% saar between December and April. Hourly wages climbed 4.8% y/y in May, more than twice as much as consumer prices. Two factors have worsened inflation prospects: the surge in energy and food costs, that every economy is experiencing, and some retracement in the Canadian dollar, which had previously held down import costs. Against the U.S. dollar the C-dollar rose 7.9% per annum in the five years to 2007 based on annual average levels. From trough to peak, it had soared 78.7% from CAD 1.61.94 on January 21, 2002 to CAD 0.9061 on November 7, 2007. But the Canadian dollar is now trading 11.5% below that peak even though its year-to-date mean value of CAD 1.0047 per USD is still 6.8% above its 2007 mean value of CAD 1.0734.

The Bank of Canada’s statement tomorrow is likely to signal a shift to a wait-and-see policy stance with new language language claiming something along the lines used at similar junctures in the past. At the end of a series of cuts with the last move coming in April 2004, for instance, officials said, “the risks to the outlook now appear balanced.” The statement will be released at 09:00 EDT (13:00 GMT) on Tuesday.



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