Canadian Policy Interest Rate Is Back in the Neutral Range

Mind the Gap

While the past gains in the Canadian dollar and intense global competition in manufactured goods are dampening inflationary pressures, the domestic supply-demand balance remains a key determinant of future inflation in Canada. In the bank's view, the economy operated "at, or just above, its production capacity" in the first quarter. This is a slightly more hawkish statement compared with an earlier estimate that the economy operated at its full capacity. In Global Insight's opinion, the fact that the unemployment rate has fallen to a 32-year low of 6.3% in March supports the bank's assessment of the output gap.

Future Growth

The Bank of Canada contends the global economy exhibited "a little more momentum than had been anticipated." Although the bank has kept its 2006 Canadian GDP growth forecast unchanged at 3.1%, it raised the 2007 forecast from 2.9% in January to 3.0%. The bank has also adjusted its assessment of risks for next year: they are now balanced, compared with "tilted to the downside." The "tilt to the downside" has been both reduced and pushed back to 2008.

The bank assumes stronger U.S. real GDP growth than Global Insight. While the bank looks for growth to remain above 3% in 2007, we anticipate the pace to be significantly below 3%. Regarding crude oil prices, the bank anticipates the price of WTI oil to stay slightly above US$70 per barrel. In contrast, we expect oil prices to fall below US$60 in 2007. The more-bullish outlook for the U.S. economy and oil prices explains why the bank is more optimistic about Canada's real GDP growth forecast.

The assumption about the Canadian dollar that underlies the bank's economic forecast calls for a small appreciation relative to the U.S. dollar late in the projection period, i.e., sometime in 2008. This is not too far off from our own forecast that sees the Canadian dollar averaging 87.5 U.S. cents in 2006, rising to 88.1 in 2007, and falling back to 87.5 in 2008.

Inflation Forecast

The bank's inflation projection is not so much a forecast as a target. Given the assumptions about external demand, commodity prices, and the dollar, the path of interest rates is set so that the resulting profile of the output gap will allow core consumer price inflation—excluding the impact of a likely cut in the GST tax—to hit the midpoint of the 1-3% target band. In every previous policy report, inflation was expected to return to the 2% midpoint, and the April edition retains this view.

Financial Market Implications

Based on our outlook, Global Insight assumes that the bank will raise the overnight rate one more time by a quarter percentage point, to 4.25%, before going for an extended break. The more-optimistic outlook for the Canadian economy by the Bank of Canada, however, raises the odds of one or two more rate hikes later this year. In our view, monetary policy tightening beyond the 4.25% level will depend on incoming data. In particular, the bank is expected to wait until the second half of the year to assess the impact of the cumulative rate hikes since September 2005, and then take stock of the momentum in the global economy, commodity prices, and the Canadian dollar.

The Bank of Canada's outlook for the Canadian economy is more robust than the consensus. This implies that market participants will adjust upward their expectations for Canadian interest rates and, therefore, the Canadian dollar. Indeed, the Canadian dollar rose in North American trading by late Thursday morning to 89.0 U.S. cents, from yesterday's closing rate of 88.6 U.S. cents.

by Wojciech Szadurski