Friday, January 23, 2009

Bank of Canada's Monetary Policy Report Update Fleshes out Details of Economic Forecast

Bank of Canada's Monetary Policy Report Update Fleshes out Details of Economic Forecast

The statement issued by the Bank of Canada following Tuesday's policy meeting when the overnight rate was cut by 50 basis points to 1% indicated significant revisions to the Bank of Canada's economic outlook for Canada, with the real GDP forecast to contract by 1.2% in 2009, a marked downgrade from the October forecast for a 0.6% increase. The details of this forecast change were released in this morning's Monetary Policy Report Update.

The quarterly pattern of growth in Canada shows that the Bank expects the recession to deepen in early 2009 and forecasts that after a 2.3% drop in real GDP in the fourth quarter of last year, the economy will contract at an annualized 4.8% in the first quarter of 2009 and post a 1% contraction in the second. Thereafter, the combination improving credit conditions, monetary and fiscal stimulus and improving demand for Canadian exports will return the economy to positive growth rates with strong gains expected in 2010. The Bank expects the recovery will be "faster than either of the recoveries following the 1981-82 and 1990-92 recessions." The ability of monetary policy to "react in a timely and significant way" combined with "fiscal flexibility" and "stronger corporate balance sheets" is offered as support for this view. Real GDP is forecast to increase by 3.8% in 2010, up from the October forecast of 3.4%.

For the U.S. economy, the central bank said that the recession will last through the third quarter of 2009 and the annual growth numbers provided showed a more significant contraction is expected in 2009. US real GDP is forecast to contract by 1.7% in 2009, a downward revision from the -0.1% forecast in October. As in Canada, the Bank expects activity to rebound in 2010, although the improvement has been scaled back with real GDP forecast to expand by 2.6%, down from 3.2% in the previous forecast. The Bank attributes the return to positive growth rates in the global economy and the US to credit conditions eventually normalizing, accommodative fiscal and monetary policy restoring domestic demand, the drag from the housing market correction diminishing.

The downward revisions to growth contributed to the central bank significantly reducing their outlook for inflation in Canada this year. In the October report core inflation was expected to bottom at 1.5% and average 1.7% this year. Increasing slack in the economy along with "modest decreases in house prices" points to the core inflation rate bottoming at a lower 1.1% and averaging 1.5% this year.

These same factors have also contributed to overall inflation being revised lower, although the extent of the cuts are more sizeable reflecting a downward revision to the outlook for energy prices. For example, WTI oil prices have been cut from an average of US$83/barrel in the October profile to US$52/barrel. As a result, overall inflation is expected to "dip below zero for two quarters in 2009" and average 0.2% this year, well below the 1.4% projected in October.

As a result of the lower starting point and growing slack in the economy, both the headline and core inflation rates are not expected to return to the 2% target until the first half of 2011, much later than expected in the October Report. While the Bank states that the outlook faces "a high degree of uncertainty" they conclude that "risks to its inflation projection are roughly balanced."

Today's MPR Update incorporates a significant amount of bad news for Canada's near-term economic performance, although it retains optimistic that both fiscal and monetary policy actions and support from the weaker Canadian dollar will set the course for a recovery in the second half of the year. With the policy rate already at an extremely low level, we think that the data would have to severely disappoint the Bank's rather dismal outlook before policymakers would embark on a policy mirroring the Fed's shift to quantitative easing.

This week's reports on manufacturing, wholesale and retail activity were dismal and point to a hefty contraction in economic activity in November and a sharp weakening in the fourth quarter as a whole. The Bank's assertion that policy is "starting to gain traction" provides a glimmer of hope that the economy is now treading through the worst. Our baseline view remains that the overnight rate will be held at 1%, although the Bank's commitment to "monitor carefully economic and financial developments in judging to what extent further monetary stimulus will be required to achieve the 2 per cent inflation target over the medium term", leaves the door open to more rate cuts if the economy's decline appears to be more acute or longer lasting.

RBC Financial Group

The statements and statistics contained herein have been prepared by the Economics Department of RBC Financial Group based on information from sources considered to be reliable. We make no representation or warranty, express or implied, as to its accuracy or completeness. This report is for the information of investors and business persons and does not constitute an offer to sell or a solicitation to buy securities.

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