Bank of Canada Quarterly Policy Report: Highlights and Inferences

July 22, 2010

After two 25-basis point hikes of the Bank of Canada overnight interest rate target, such stands currently at 0.75%, a level that still represents considerable stimulus.  One infers from tables in the new Monetary Policy Report that all remaining stimulus will be removed no later than the end of next year at which the stance will be at least neutral and possibly marginally restrictive.

There is still excess supply in the Canadian economy, but it quantifies to only 40% of what existed three quarters ago.  The degree of excess demand is called the “output gap,” which bottomed at negative 3.7% in 3Q09 but was probably about minus 1.5%, according to central bank estimates, at the middle of 2010.  If this rapid rate of slack removal were to persist, the output gap would reach zero by next spring.

Official perceptions about the output gap play a critical role in guiding the path of Canadian monetary policy.  The size of the output gap is influenced by the interplay of the rate of potential GDP growth – how rapidly GDP would increase if all resources were fully utilized – and actual GDP.  Potential GDP is expanding a bit faster this year than in 2009, and actual GDP is projected to rise much less quickly following annualized spurts of 4.9% in the final quarter of 2009 and 6.1% in the first quarter of this year.  That’s why it will take until 4Q11, not 2Q11, for the output gap to be melted completely, so monetary officials have more time in which to restore normal interest rate settings.

The notion of “normal” or “neutral” interest rates has not stayed fixed over time.  In Canada’s case, such has been drifting downward since inflation-reduction targets were introduced in the early 1990s.  Inflation expectations are much better anchored now than in the past, and less monetary drag is required to sustain price stability than was historically the case.  The last four cyclical peaks of the Bank of Canada’s benchmark rate target occurred at 9.0%, 5.75%, 5.75%, and 4.75%.  Being peaks, these levels represented restrictive settings at the time they were imposed.  Neutral levels were lower. I suspect the new normal rate setting will be somewhere between 3.0% and 4.0%, and it’s more likely to be lower than that range floor than above the band’s ceiling.

Bank of Canada officials define price stability as consumer prices rising 2.0% per annum.  Core CPI is used to steer policy in the short term, but total CPI is the pertinent variable to stabilize in the long run.  New macroeconomic forecasts pencil in growth averaging 3.0% annualized from 2Q10 until 2Q11, then downshifting for two quarters to about 2.5%, and finally hovering at 2.0% throughout 2012.  Core and total inflation are projected to be at 2.0%, give or take two-tenths, from the present quarter until the end of the forecast time horizon.

External factors will be responsible for slower growth.  Assuming that the European sovereign debt crisis subtracts 0.2, 0.6, and 0.8 percentage points form Euroland GDP in 2010, 2011, and 2012, the report estimates respective drags on the United States and Canada of 0.1% each in 2010, 0.4% and 0.3% in 2011, and 0.3% and 0.2% in 2012.  Partly as a result, the new report revises projected GDP growth in 2011 downward by 0.5 percentage points (ppts) to 3.0%  in the case of the United States, 0.4 ppts to 1.2% in the case of the euro area, 0.2 ppts to 1.5% in Japan’s instance, and 0.3 ppts to 3.8% for the world minus the above three economies and China.  In spite of recent concern that Beijing officials might subject China to too much restraint, projected Chinese growth rates of 9.2% in 2011 and 8.7% in 2012 are practically identical to what Bank of Canada officials had assumed in the prior April Policy Report.  

Canadian calendar year growth of 3.5% in 2010, 2.9% next year, and 2.2% in 2012 leaves it near the top of the Group of Seven leader board.  Much of this strength is associated with Canada’s commodity-exporter status; Australia will likely perform even better but is not in the G-7.  Another part of the success relates to the comparative health of Canadian public finances.  The composition of Canadian growth will be changing much more than the overall GDP expansion rate during the period.  Final domestic demand is projected to account for 4.0 percentage points of economic growth in 2010 but just 1.8 ppts next year.  Support from inventories will amount to just 0.3 ppts in 2011, 0.8 ppts less than in 2010.  Net exports, on the other hand, are expected to enhance 2011 growth by 0.8 ppts after depressing GDP growth in 2010 by 1.6 ppts.

Slower projected Canadian growth in 2Q10 than 1Q10 was corroborated by May data yesterday and today.  Wholesale turnover slid 0.1% on month and by 1.5% in volume terms.  Retail sales dipped 0.2% after a 2.0% decline in April.

Economic forecasting is very inexact and humbling whether practiced by private-sector analysts or officials.  An obvious problem with the new Canadian estimates is their lack of volatility.  The real world seldom, if ever, delivers such smooth results especially in this age of “unusual uncertainty.”  In fact, it is conceptually imprecise to interpret forecasts from the Bank of Canada in the same way one would view forecasts from a money center commercial bank.  Rather they show what monetary officials seek to achieve, and major deviations from that path are apt to evoke mid-course corrections in monetary policy.

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



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