Inflation potential wrench in BoC plans

The Canadian economy surprised Bank of Canada officials this month. Although the economy remains in line with most of the Bank’s January predictions, the April Monetary Policy Report says inflation — which is slightly outpacing the Bank’s target of 2% — is the one glaring exception.

The unexpected increase is largely due to an unforeseen increase in Canadian production output and a Consumer Price Index increase. Fruit and vegetable prices rose unexpectedly as a result of weather-related reductions in North American supplies, while gasoline prices were higher than projected due to temporary production problems at oil refineries. Housing prices also remained quite high.

In its report, the BoC says it expects the CPI to rise to 2.8% by the end of 2007. One of the key factors in this increase is the price of crude oil, which is expected to hit $70 a barrel by the end of 2007 and remain in that range until 2009.

Despite this, the report suggests that long-term and medium-term inflation factors are relatively stable. The Bank’s current projections call for core inflation to remain above 2% in the coming months, then return to 2% by the end of the year and remain there until the end of 2009.

“With the economy projected to return to its production capacity in the second half of this year, and with further easing of pressures from housing prices, upward pressure on core inflation is expected to moderate, bringing core inflation back to 2% by the end of 2007,” BoC governor David Dodge says. “The Bank continues to judge that the risks to its inflation projection are roughly balanced, although there is now a slight tilt to the upside.”

The BoC reports that available information suggests real gross domestic product (GDP) grew by about 2.5% in the first quarter of 2007, close to the 2.4% rate projected in January.

Much of this growth can be attributed to strong domestic demand. The BoC says solid employment growth, a rise in real personal disposable income numbers, rising household credit and net worth all contributed to ongoing strength in consumer spending. This growth is partly offset by a longer than expected slowdown in the U.S. economy, which will continue to drag down Canadian exports, particularly in the automotive and lumber industries.

The BoC has slightly reduced its growth projection for Canada to 2.2% in 2007. It expects the U.S. economy will recover and increase Canadian exports, which, in turn, will increase projected growth to 2.7% for 2008 and 2009.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com