News: Canadas tilt to the downside

Wed, 17 Oct 07

With a flexibility that has been honed to a point just as he is about to exit the stage, Bank of Canada Governor David Dodge put Canada's recent strong economic performance in the background on Tuesday and focused firmly on potential pitfalls opening the door -- just a crack -- to a potential rate cut...

The 33-year low unemployment rate, blistering housing market and punchy wage gains may look peachy but not so much when put against a soaring dollar and slowing U.S. growth, the bank said in its interest rate announcement yesterday. The bank's conclusion: the risk to its inflation projection now has "a slight tilt to the downside."

"Clearly the bank is biased now towards a more accommodative bent," said Aron Gampel, deputy chief economist at the Bank of Nova Scotia. "It is quite a turn. It's not the first one done by the Bank of Canada and it probably won't be the last."

Just this July Bay Street was settling in for a series of rate hikes from the Bank of Canada after an initial increase to 4.50%. But the credit market blowup piled on top of the U.S. housing slump darkened the outlook.

Negative outlook

The bank's outlook for U.S. growth is more negative than most. It sees 1.9% for this year against a consensus of 2.0% and only 2.1% next year versus a consensus of 2.4%.The Canadian dollar has soared well above the bank's expectations. In July, it was trading in a range of US93 to US95.5 but after rising as sharply as US1.03 the bank's new projection is for US98.

The dollar has become one of the bank's main downside risks: "If the Canadian dollar exchange rate were to persist above the US98 level...for reasons not associated with stronger-than-projected demand for Canadian products, Canadian output and inflation would be lower," the bank said. Past appreciation could also begin to show through.

The bank was also quite explicit on how the recent credit market turmoil might affect the cost of borrowing for consumers and firms, saying it has acted like a 25 basis point rate hike. While Canadian growth was marked up to 2.6% from 2.5% for 2007, it was marked down to 2.3% for 2008 from 2.6%.

"The deflationary impulse that's coming from a slowing U.S. economy and the housing and automobile correction suggest policy has tightened already too much with the help of the currency, the last interest rate increase and the dislocations we've seen in credit markets," Mr. Gampel said. "On balance, there is a shift in sentiment going on."

That does not mean the bank is not alert to inflation risks. It mentions two specifically: higher growth in household spending and lower productivity growth than assumed.

2008 outlook ‘murky’

Dale Orr, chief economist at Global Insight also sees a third: "When I see where the core rate has been for the last year [above the bank's 2% target], it's being driven by wage rates," he said. "My leaning would be the bank would have to have a [rate] increase early next year to bring the core rate down to 2% by mid-or late next year."

Many economists see the bank on hold at its December announcement but the outlook for 2008 is still murky with some seeing a cut and some seeing a hike. It is interesting the bank mentioned productivity growth again. For as one economist mentioned last week, if all we are getting from our 5.9% low unemployment rate is measly 2.6% growth, what are all these people doing?

Productivity improvements reduce costs and boost efficiency; weak productivity growth can be inflationary. With the statement yesterday, Mr. Dodge joins Ben Bernanke, the U.S. Fed chairman in offering a more cautious outlook for the North American economy.

Mr. Bernanke said the housing contraction would have a significant drag on growth but it was too early to tell what impact it would have on spending. After shrugging off their summer troubles, markets now also seem a little more cautious, with volatility having returned.



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