Welcome to the trough: BoC

While the Bank of Canada’s Monetary Policy Report confirms the outlook for growth in 2009 and 2010 will remain broadly unchanged from its April Report, it has considerably toned down the risk of a sustained economic decline.

At the time of the April Report, the Bank had projected the recession in Canada would deepen further and that a muted recovery would start in the fourth quarter of 2009. However, with the economy supported by better financial conditions and higher levels of business and consumer confidence than anticipated, the downturn in activity in the first half of the year has been less severe, and BOC now projects the growth will turn positive in the third quarter.

Since the April Report, overall financial conditions in Canada as measured by the Financial Conditions Index have already shown improvement. The perceived riskiness of equities and corporate bonds has declined, since investors have become more confident that the policy measures taken worldwide have mitigated the decline in the global economy.

Mark Carney, governor of the Bank of Canada, reiterated the bank’s optimistic stance, “Global economic activity appears to be nearing its trough, and there are increasing signs activity has begun to expand in many countries in response to monetary and fiscal policy stimulus and measures to stabilize the global financial system.”

He chose, however, to call the recovery nascent. “To sustain global growth, effective and resolute policy implementation remains critical.”

On Tuesday, the Bank left its key interest rate unchanged at 0.25% and made a commitment, conditional on the inflation outlook, to keep the policy interest rate at that level until the end of the second quarter of 2010.

“The recovery will initially owe much to monetary policy, which has been very aggressive, and to fiscal policy, which is beginning to have an impact,” Carney noted.

The Bank expects Canada’s economy to contract by 2.3% this year and then grow by 3.0% in 2010 and 3.5% in 2011. Annual U.S. GDP is projected to decline by 2.4% in 2009, and to grow by 1.4% in 2010 and by 3.4% in 2011. Globally, the economy will shrink by 1.7% in 2009, followed by growth of 2.3% in 2010 and 3.9% in 2011.

This gradual recovery of the global economy is underpinned by several critical factors. First, extensive support to the financial sector, together with reduced uncertainty about the macroeconomic outlook, should contribute to a further normalization of financial markets, resulting in lower borrowing costs and increased availability of credit to businesses and households. Second, the aggressive fiscal and monetary stimulus already in place should help restore consumer and business confidence, and raise domestic demand. Third, once corrections in the housing sectors of several economies are complete, a significant drag on growth will be removed. Finally, completion of the inventory cycle, most notably in the auto and IT sectors, together with a resumption of cross-border trade flows, should support the global recovery.

However, structural adjustments — most significantly in the auto sector — are expected to progress slowly, and rising unemployment and negative wealth effects will restrain consumption and investment. The protracted nature of the recovery will add to excess production capacity in the global economy, holding down wage and price inflation.

Measures of near-term inflation expectations have risen somewhat from very low levels in recent months, reflecting increases in commodity prices as well as improved market sentiment and consumer confidence.

Core inflation, however, is expected to decline to a trough of 1.4 per cent in the fourth quarter of 2009, reflecting the significant excess supply in the Canadian economy and a continued deceleration in food prices. But with excess supply being absorbed gradually, and with inflation expectations well anchored, it is projected to return to 2% in the second quarter of 2011.

The main upside risks to inflation relate to domestic factors, and the possibility that the momentum in economic activity will be stronger and more sustained than currently anticipated. While the Bank’s latest base-case projection already incorporates a somewhat faster pickup in domestic demand than had been expected in the April Report, the recent rebound in consumer confidence, coupled with improvements in financial conditions, could lead to less precautionary saving, stronger growth, and an earlier return to the 2% inflation target. Another upside risk to inflation is the possibility that potential output will be lower than the Bank’s revised estimate, if the extensive restructuring in certain sectors is more protracted and the investment response more delayed than currently envisaged.

The principal downside risks to inflation relate mainly to the external sector. The restoration of normal financial conditions could be more gradual than expected and further setbacks cannot be precluded — triggered, for example, by unexpected losses at financial institutions or by escalating concerns about current account and budgetary imbalances. Such developments could have serious spillover effects in Canada through trade, financial, and confidence channels. Importantly, a stronger and more volatile Canadian dollar could act as a significant drag on growth and put additional downward pressure on inflation.

(07/23/09)