Central bank expects smooth sailing

The Bank of Canada has released its latest Monetary Policy Report Update, assuring Canadians that the economy is unfolding as expected, despite a shift in who is buying the goods and services we produce.

“There was a further shift in the composition of demand towards consumption and away from exports,” the central bank said in its report. “This additional strength in domestic demand is expected to persist into next year, but it should be more than offset by a weaker outlook for net exports, owing primarily to the recent strength in the Canadian dollar.”

Many bank-watchers were surprised when it decided not to raise its trend-setting overnight rate earlier this week, standing pat at 4.25%. The decision was based on the bank’s economic forecast, which sees a slowdown in growth starting later this year and extending to 2008.

“The economy is currently judged to be operating just above its production capacity,” the bank said in the report. “With some anticipated moderation in U.S. economic growth, combined with past interest rate and exchange rate increases, the Canadian economy is projected to return to its production capacity by the end of 2008.”

Meanwhile, inflation is expected to average just 1.5% through the remainder of 2006 and through mid-2007, before rising once again to the bank’s target zone of 2% in late 2007.

Many Canadians have started questioning the official inflation rate as compiled by StatsCan in its calculation of the consumer price index. The soaring price of gasoline is often cited as evidence that real inflation may actually be much higher, especially as it raises the cost of transporting other consumer goods.

Such concerns are understandable, says TD Bank economist Steve Chan, but misguided. “It is easy to assume price increases in one or two items are representative of the overall inflation index — if gasoline prices are soaring, than the CPI must also be soaring,” he says. “This would be true if gasoline was all you consumed, but gas only makes up about 5% of total spending.”

Consumers are more keenly aware of gasoline prices than most other products they purchase. Rising food prices are also acutely felt. But while these categories are among the most volatile, Chan points out that they also make up a very small amount of the average consumer’s monthly budget.

By far the largest single component of the CPI measurement is the cost of housing. While rising interest rates have increased the cost of carrying an adjustable rate mortgage, consumers with fixed rate mortgages would only see an increase if their mortgages had come up for renewal.

At the same time that house prices and mortgage payments have been increasing, rental housing has not kept pace with the overall inflation rate. “With home prices rising rapidly, some groups have made the choice to rent, as rental prices haven’t risen to the same degree,” Chan says.

Other consumer prices, ranging from clothing and footwear, recreation, and health and personal care, have not kept pace with the overall 2% average CPI growth.

While the Bank of Canada expects this trend of low and stable inflation to continue, it cautions that risks remain.

“The upside risks to Canadian output and inflation relate primarily to the momentum in household spending and housing prices,” it said in the Monetary Policy Report. “The main downside risk for Canada is that the U.S. economy could slow more rapidly than expected, reducing demand for Canadian exports.

“Because of the possibility of a disorderly resolution of global current account imbalances, the balance of risks is tilted slightly to the downside later in the projection period.”

The central bank’s official “base-case” call on the global economy is less threatening, however, with global growth expected to ease from its current 4.8% rate, to 4.6% in 2007, and to 4.4% in 2008.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(07/13/06)

Steven Lamb