A Closer Bank of Canada Call Than Generally Realized

September 2, 2008

The sixth of eight scheduled Bank of Canada rate announcements in 2008 will be made Wednesday at 13:00 GMT (09:00 local EDT).  Four rate cuts were implemented between December 2007 and April 2008, the first two by 25 bps and the last two by 50 bps to 3.0%.  My baseline forecast of no change is a fairly universal view, but I suspect that most analysts see the decision as a much closer call than the conventional wisdom at the time of the previous rate announcement in mid-July or even what they were thinking a week or two ago.

Monetary officials in Canada face the classic dilemma of their counterparts in other economies.  Canadian real growth contracted 0.2% saar in the first half of 2008, that is between 4Q07 and 2Q08.  Second-quarter growth of 0.3% saar was less than half the central bank’s forecast, and first-quarter growth was revised to a slightly bigger drop.  On the other hand consumer prices rose 4.5% saar over the first seven months of 2008 and by 5.0% saar during the six months to July.  That is substantially above a target of 2.0% and an operational upper guideline of 3.0%.  Such may give pause to any thought of cutting rates yet even though core inflation has behaved decently.  In July at the time of its previous meeting, officials called policy, with a 3.0% overnight target of 3.0%, appropriate.  They projected both core and total inflation converging upon the 2.0% target in 2H09 and considered risks to that forecast to be balanced.  July inflation was more or less consistent with the view of officials, but a key assumption of the medium-term forecast — oil prices averaging between $141 and $143 in each half year to 2010 — now appears much too pessimistic.  Weaker growth in 1H08 means greater excess supply in the economy during 3Q08 than thought previously and a return to full employment of labor and capital not occurring as soon as the mid-2010 date indicated in the July report.  Lower oil costs and greater excess supply give officials two choices.  They could wait longer into 2009-10 before starting to lift interest rates, or they could cut rates in the near term, creating a lower starting point for tightening than they had envisaged.  The decision regarding whether to pursue the option of another rate cut is likely to hinge on their view of U.S. demand prospects in 2H08 and 1H09, their confidence that oil price declines will not reverse soon and may even become greater, and any evidence or lack thereof that expected inflation may be creeping higher as a result of above-target actual inflation.



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