Canada Monetary Policy Monitor

Daily Forex Fundamentals | Written by TD Bank Financial Group | Aug 29 08 23:18 GMT |

HIGHLIGHTS With the Canadian economy unambiguously weak, and recent inflation starting to show some indications of moderation, there is indisputably an argument for the Bank of Canada to cut rates on September 3. However, there are a few reasons why the Bank of Canada is more likely to leaves rates unchanged than to cut, including U.S. economic resilience, and high alternative CPI measures. Recent rhetoric from the Bank of Canada continues to support a neutral bias. The communiqué will be in focus, but the tone is unlikely to significantly change from the last one. TD forecasts an unchanged overnight rate at the September 3 FAD. Since the Bank of Canada decided to keep rates on hold at 3% at the July 15 Fixed Announcement Date, there has been a rather significant shift not only in the economic data, but also in how the market is pricing in future rate moves by the Bank. The accompanying statement to the July 15 meeting indicated a neutral bias, saying that "the current level of the target for the overnight rate remains appropriate" and risks were balanced. Since then, however, a raft of soft economic data has prompted the market to price in a rate cut. The economy is unambiguously weak and the slowing economic activity has had some impact on inflation. But in our view, this does not suggests a slam dunk case for a rate cut. In fact, it seems as though the Bank is comfortable with the overnight rate at 3%. Recent comments by Deputy Governor Longworth reinforced a neutral bias when he spoke on August 26. There remains some uncertainly with respect to where inflation will go in the near term and there remain subtle points of strength in the economy and inflation. Moreover, though as a secondary consideration, is the fact that the Bank has already surprised the market once this year with its decision in June to keep rates steady. There is some degree of credibility risk associated with making a move when the market is mostly pricing no change in the overnight rate. As such, by keeping rates on hold on September 3, the Bank gives itself a bit of breathing room to see how conditions unfold and avoid the market's ire. Thus, we maintain the view that the Bank of Canada will remain on the sidelines on September 3, leaving the overnight rate at 3%. Inflation Looks Less Threatening A slowing Canadian economy means the output gap will move further into excess supply. In turn, that will take some of the pressure off inflation, and indeed, there has already been some evidence of that. The recent inflation data has certainly come as a welcome surprise. In July, core CPI was a touch soft, with a 0.1% SA M/M gain, leaving the annual rate at 1.5%. Headline CPI remained somewhat elevated with a 0.35% SA M/M gain. On an annual basis, headline CPI rose to 3.4%, which is the highest of the cycle, as food and energy prices continue to figure in to the calculation in a big way. Food prices were up 0.6% M/M in July, which is slightly softer than the prior three months, but still relatively robust. Energy prices were also up 2.3% M/M in July, and were helped only modestly by the incipient fall in overall commodity prices. But even while headline inflation continues to advance above the top end of the BoC's inflation target band of 3%, it appears to be peaking on an M/M basis, and there has been fortunately little pass through to core prices. That is good news for the Bank of Canada, and points to downside risk in the futures, which the Bank acknowledged, itself. The breakdown in the inflation data suggests that the slowdown in the Canadian economy is starting to have some impact on prices, and will continue to do so as the economy moderates further. Prices for goods were up only 0.4% M/M in July, after averaging 1.05% M/M in the prior quarter. Moreover, services inflation seems to be moderating as well, with only a 0.25% M/M gain in service prices in July. But both are still elevated when compared to a year ago. Goods inflation rose to 3.2% Y/Y in July, and services remained relatively elevated at 3.5% Y/Y. But continued softening in economic activity should put a lid on goods prices going forward. In turn, that should prevent any significant gains in core inflation. On the labour market front, any wage pressures that were previously present, have now abated, as the labour market continues to lose steam. Canada has lost 60.2K jobs in June and July and that has taken much of the froth off wage pressures. In this cycle, average hourly wages peaked at 4.9% Y/Y in January, and by July, they were 3.8% Y/Y. As the economy cools further, so too will job growth and workers will ultimately have less bargaining power. In turn, that will further limit wage pressures. Any business sector price pressures have also moderated recently as well. At 79.8%, capacity utilization is now lower than the last recession in Canada, and only 2.1 percentage points higher than the historical low of 77.7% posted in the 1991 recession. Canadian businesses are obviously well aware of the impact that a weak U.S. economy will have on demand for Canadian goods. As such growing economic slack should keep the reins on inflation. The disconnect between headline and core CPI is expected to narrow going forward, and by the second half of 2009, the Bank expects both to be at 2%. That in itself provides some leeway for the Bank to stand back and assess conditions. Uncertainty Lingers But while the outlook for inflation going forward looks tame, there is still some uncertainty. First, the alternative inflation indicators that the Bank of Canada cares about do not look as tame as the reported inflation data and are trending around the 2-3% range. Second, the Bank has noted some concern about pass through from prior commodity price increases through to headline inflation. Third, energy prices have fallen quite dramatically through August, which suggests that July might be the last time that they factor in to headline inflation so heavily. In July, it was not gasoline prices that drove the energy component of headline inflation, but rather natural gas. The former only rose 1.2% M/M, while the latter rose a massive 8.8% M/M. Gasoline prices have dropped about 5% since July, as demand destruction heats up, which suggests some moderation in the energy price component in upcoming months. Still, energy prices are not governed solely by logic alone, and energy prices could very well begin to rise again, especially if the hurricane season yields some bad storms. This is a risk the Bank must watch for. Fourth, food inflation could be a different story, yet again. Food comprises 17% of the Canadian CPI basket and until recently, Canada has enjoyed a period of relatively subdued food prices. This is particularly true when compared to other developed countries, which have had to content with rapidly rising food prices. This has been the result of a handful of factors like the recent strength of the Canadian dollar, which has now reversed course, and a one time spate of price competition, which have kept prices contained as new grocers fought for market share in Canada. But demand destruction is not really an issue for the food market, and so significant future upside risk remains for food. Fifth, the Canadian dollar has lost just over 4% since July 15, and with the bull market in commodities now largely in the rear view mirror, we expect the Canadian dollar to ease further against the U.S. dollar. This creates an uncertain interplay between the two drivers, and likely leaves the Bank of Canada loathe to act until there is a clear direction in all inflation trends. Canada's Growth Story Winds Down Second quarter GDP was not as bad as feared, but certainly lower than expected and it missed the Bank's forecast by a sizable margin. GDP posted a 0.3% Q/Q, annualized gain, and first quarter GDP figures were revised down significantly to -0.8% Q/Q, annualized (compared to a decline of 0.3%). It is clear growth in Canada has embarked on a softening trend. Fortunately, it has not entered a technical recession, but softness is still prevalent. The drivers of growth in the second quarter were primarily from consumption, government spending and inventories. Growth is expected to remain lacklustre in the second half of the year, as the headwinds from the recession bound U.S. economy weigh on Canada. But even with slower Canadian growth, given the atrocious productivity performance in Canada, slower growth is unlikely to open up as much slack as one would expect. Thus, it seems unlikely that lacklustre growth will sway the Bank away from the sidelines. It admitted earlier this week that the risks were to the downside, but that it nonetheless retained a neutral bias. As such, this bolsters our case for the Bank to keep rates steady at 3%. Slow and Steady Wins the Race Although Canadian credit conditions have continued to stage a broad-scale improvement, there are still some lingering signs of stress. One of the best indications that Canadian credit markets are improving is the fact that the Bank of Canada recently ended its Term PRA program in July. The Bank did not renew the $1 billion term PRA citing that "conditions in Canadian markets have improved since the end of April, including funding conditions out to three months." But that is not to say that credit markets are back to where they were before the crunch hit. As Governor Carney said the Q&A following the July Monetary Policy Report Update, current conditions and spreads might be the "new normal". And perhaps the best evidence of this new normal is the fact that the three month CDOR versus OIS spread has remained contained, but it is nowhere near the 10bps that characterized the period prior to the credit troubles last year. But there have been some subtle upside surprises recently, despite much of the economic doom and gloom in Canada. Notably, U.S. GDP has surprised to the upside and has implications for Canadian GDP. Moreover, household credit growth in Canada remains robust. In fact, of the three major developments cited in the last communiqué, the U.S. economy has unfolded better than expected, while commodity prices have fallen quicker than expected. This combination suggests that the Bank does not have much room to make any significant reversals and will need to be sure on the direction of rates before it pulls the trigger. Statement Will Likely Retain Neutral Bias Given that this decision will be in between Monetary Policy Reports, it is unlikely that this statement will offer as much detail as the last one. Moreover, since our expectation is that that the Bank will keep rates steady on September 3, the focus will once again turn to what the Bank says in the communiqué. And on that front, there might be some important nuances, even though fundamentally, the Bank's outlook has probably not materially changed. As such, the statement that "the Bank judges that the current level of the target for the overnight rate remains appropriate" is likely to remain a fixture in the communiqué, in addition to a statement that the risks remain balanced. There perhaps is a risk that the Bank removes the statement about rates being "appropriate", especially if there is growing uncertainty about the direction of rates. But ultimately we think that they will retain it. As such, it is likely that the statement will stick to the broad outline set out in the last statement, and maintain a generally neutral bias. Instead, the distinctions might be in how they present the risks to the outlook. Given that there is still considerable uncertainty about the prospects for Canadian inflation, we think that the Bank will say that inflation risks are "balanced" or "roughly balanced" At the extreme they might temper it by saying that there is a slight tilt to the downside, but all should suggest unchanged rates more likely than not at future decisions. Outlook for Rates Since there are both upside and downside risks to inflation, that argues for the Bank of Canada to stay on the sidelines in the very near term. The risk going forward, however, is that the Canadian economy disappoints, and reveals further moderation in inflation trends. If this were to occur, the Bank's next move could conceivably be a rate cut. But we still think that this still has a relatively small chance of happening and we expect the Bank of Canada to keep rates steady at 3% for the remainder of 2008 and once the economy begins to improve in 2009, the risk will begin tilting towards a normalization of rates. TD Bank Financial Group The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.