Unchanged Bank of Canada Policy

April 12, 2011

The overnight target interest rate in Canada has been left at 1.0% as most forecasters predicted and will continue to be flanked by a 0.75% deposit rate and a 1.25% Bank Rate.  The continuing strength of the Canadian dollar was mentioned twice in an otherwise upbeat statement, which upgrades the global economic recovery to “more firmly entrenched” and revises projected Canadian GDP growth in 2011 to 2.9% from 2.4% predicted in January.  Most importantly, the exhaustion of unused productive resources is now seen happening by mid-2012, two quarters sooner than thought before.  All things else being equal, that forecast shift would require the pace of rate normalization to be brought forward by about two quarter.  So why not raise the key interest rates by 25 basis points now, rather than wait until the next policy announcement of May 31st at the earliest?

The answer seemingly lies in the appreciated Canadian dollar, 1.7% stronger than at the time of the last policy announcement on March 1 and up 4% in the past four weeks.  Officials believe that the loonie’s strength presents further “competitive challenges” and will restrain the expected improvement in net exports.  Coincidentally, Canadian trade data for February released earlier today showed a 4.9% monthly plunge in exports and a drop of the trade surplus to CAD 34 million from CAD 381 million in January and CAD 1.923 billion in December.  In turn, “persistent strength of the Canadian dollar could create even greater headwinds for the Canadian economy, putting additional downward pressure on inflation through weaker-than-expected net exports and larger declines in import prices.”   So while total inflation is likely to spike to 3% in the next couple of months and core inflation is projected to rise to its targeted 2.0% some 15 months from now, downside inflation risks associated with that forecast allow policy to pause at the moment.

Four disinflationary factors are identified: the slow absorption of excess supply, modestly rising labor costs, a recovery of productivity, and well-anchored price expectations.  That being said, policy that is currently “considerably stimuluative” needs to be neutral, if not restrictive by the end of this year if one assumes a six-month lag between a rate change and its effect on the economy.  That’s just five policy meetings from now.  The cyclical low in the overnight target rate of 0.25% was first reached two years ago this month and maintained at that level until a 25-bp rate hike on June 1, 2010.  Two more increases followed in July and September of last year. A fourth rate increase would seem overdue, except that is if officials don’t really believe in their new forecast or, put differently, attach much greater downside than upside risks to the baseline projections.  The Fed’s great reluctance to normalize U.S. monetary policy creates additional qualms, as the Canadian dollar is apt to be particularly sensitive to any widening of U.S.-Canadian rate differentials.

More clues to the thinking behind today’s action will be revealed in the Monetary Policy Report, due tomorrow.

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



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