Bank of Canada Monetary Policy Quarterly Report

January 21, 2010

As always, today’s Canadian central bank policy report provides a mountain of handy information.  Several useful guideposts are provided, and then one can make inferences that illuminate even more clues about likely future policy.

Projected economic growth in 2010 was revised upward from forecasts made in October to 2.5%  in the United States from 1.8% assumed earlier, 9.3% in China from 8.9%, 1.9% in Japan from 1.7%, 1.2% in the euro area from 0.9%, and 4.0% collectively in all other countries from 3.3%, yet projected Canadian growth of 2.9% is a tenth of a percent less than predicted in the prior report released three months ago.  The reason for the downward revision to Canadian growth is a lower level of 2009 GDP than had been assumed.  Because of a surge in import demand, Canadian GDP rose just 0.4% at an annualized rate in 3Q09, 1.6 percentage points below what officials had assumed.  Canadian growth was impeded by a strong exchange rate, which if forcing a profound rotation of the source of economic growth away from net exports and toward domestic demand.  The process takes time especially if commodity-sensitive currencies continue to press upward.

The new report assumes that GDP expanded 3.3% last quarter and will advance similarly in the current quarter before accelerating to a four-quarter increase of 4.0% between 1Q10 and 1Q11.  If officials are predicting accurately, Canadian growth continued to lag substantially behind the United States last quarter but will catapult above the U.S. norm in the coming year.  In calendar year terms, there is to be a favorable 5.4 percentage point swing in Canada from a GDP contraction of 2.5% in 2009 to positive growth of 2.9% in 2010.  Business spending, inventories, personal consumption and construction account for roughly 37%, 35%, 30% and 15% of that improvement.  These shares exceed 100% because of a projected 1.2 percentage point drag from net exports on GDP growth this year.  Net foreign demand exerted a neutral growth effect in 2009.  Public-sector spending will impact economic growth positively in 2010 and to a similar degree as last year but transforms into a slight drag on growth by 2011.  Net exports becomes marginally supportive of overall growth in 2011.  The shifting growth contributions from these components of demand imply no more appreciation in the Canadian dollar and sustained economic recoveries in all other major regions of the world.  The report asserts that economic and financial developments look somewhat better now than in October.  This optimism about the global economic context belies a considerable body of weaker-than-expected data released this month and the possibility that equities could be starting on a downhill run this week (see prior post).

According to their in-house gauge of excess capacity, Canadian officials believe their economy had 3.7% more aggregate supply last quarter than aggregate demand.  When considering all other measures pertaining to capacity, that estimate gets modified to a shortfall of 3.25%.  To eliminate that much slack, actual activity must expand faster than the hypothetical non-inflationary top speed.  The latter concept, known as potential GDP growth, is estimated to be about 1.7% per annum during the coming two years.  The juxtaposition of such potential GDP increases against projected actual GDP advances of 2.9% this year and 3.5% in 2011 cuts the output gap by roughly 1.5 percentage points in each calendar year.  In fact, officials expect the output gap to disappear sometime during the third quarter of 2011, the same quarter when core and total CPI inflation, which posted respective on-year increases of 1.6% and 0.9% in the final quarter of 2009, return to the central bank’s mandated medium-term target of 2.0%.

By the summer of 2011, it will be necessary for Canadian interest rate settings to reflect a policy stance that is no looser than neutral, meaning that economic growth is neither promoted nor restrained.  But after actual assumed GDP growth of 4.0% during the prior twelve months, a restrictive stance will more probably be required to slow GDP to its long-term trend of 2.5%.  The report in fact pencils in real growth of just 3.0% in the four quarters to 4Q11.  In the last rate-tightening cycle, officials at the central bank raised their overnight money target from a floor of 2.0% in the middle half of 2007 to a peak of 4.5% some two years later.  3.5% more or less represents policy neutrality, and that level lies 325 basis points above the present 0.25% level.  If the Bank of Canada doesn’t start to raise rates until its July 2010 meeting, there will be just 10 meetings in which to cover those 325 basis points of ground by the end of 3Q11.  If economic growth is as solid as central bank officials are projecting and total and core inflation are back to 2% by then, 3.5% would not be sufficiently restrictive, so a target interest rate of slightly more than 3.5% would be prudent.

On the central bank’s own blueprint, a need for a mix of 25-basis point and 50-basis point rate hikes from this coming July is required if officials want to approach their goals in an even way.  The Fed did that in 2004-6, and the strategy looks badly flawed in retrospect.  Officials will at least probably consider front-loading the task with a move of 75 basis points or more before the mid-point of the whole exercise.  The same logic applies to other central banks including the Fed, but it has two drawbacks.  The first is that big rate increases when inflation is still acceptably low might draw considerable political criticism.  A second problem with mixing in one or two really big rate increases is that economic growth could just as easily turn out to be considerably softer than the kind of activity assumed in the Bank of Canada report.  As my prior post indicates, it’s a huge stretch of the imagination to see a normal upwardly sloped trajectory of real GDP if equities tank.  Unfortunately, stocks are presently overpriced because of the very stimulative monetary policies in place worldwide this year.  Ideally, one would like to see stock markets tread water until enough time has elapsed to justify present price levels with economic fundamentals.  But the nature of market prices is to fall if they cannot rise, not to simply hold steady until the real economy catches up.

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



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