BoC expects Canada to weather the storm

By Mark Noble | July 17, 2008 | Last updated on July 17, 2008
4 min read
A lot of gloom but no real doom underpins the Bank of Canada’s latest monetary report. The BoC expects Canada to face a number of challenges in the near term but believes the economy can ride out a period of slow growth and rising inflation.

The BoC outlined three major factors affecting the Canadian economy: protracted weakness in the U.S. economy, ongoing turbulence in global financial markets and sharp increases in the prices of certain commodities, most importantly, energy.

In its April Monetary Policy Report, the BoC had anticipated the impact of the first two factors. It admits the continued surge of commodity prices has caught it off guard, and that commodities continue to outpace earlier expectations. As a result, the BoC has altered the outlook for global and domestic inflation to the upside, particularly headline inflation, as measured by the consumer price index (CPI).

Assuming energy prices follow current futures prices, the BoC expects total CPI inflation to rise temporarily above 4%, peaking in the first quarter of 2009. In recent historical terms, this is a fairly significant jump, although not nearly as high as what is being experienced in the U.S., where CPI inflation has already hit 5%, its highest rate since the 1991 recession, according to a BMO Economics report yesterday.

According to Sal Guatieri, senior economist with BMO Capital Markets, Canada is insulated from hitting the U.S. level of inflation because of the trade-weighted strength of the Canadian currency.

“Canada should hit 3% [CPI] as early as the June report due next week,” Guatieri says. “The major difference is the currency performance. The Canadian dollar has risen 70% against the U.S. dollar over the last six years. U.S. import prices are rising at the fastest rate ever because of a weaker U.S. dollar, while Canada’s import prices are falling because of the high Canadian dollar.”

This situation underscores a dilemma for the Canadian marketplace: on the one hand, we have rising prices for staple goods like energy, which is keeping the Canadian currency buoyant and increasing income levels; on the other hand, we have negative growth in areas of the economy not involved with commodities, which are likely more dependent on the weak U.S. economy.

“Growth in the global economy has weakened since the January Monetary Policy Report update, reflecting the effects of a sharp slowdown in the U.S. economy and ongoing dislocations in global financial markets. Growth in the Canadian economy has also moderated,” BoC governor Mark Carney said in the opening statement of the report. “Buoyant growth in domestic demand, supported by high employment levels and improved terms of trade, has been substantially offset by a fall in net exports.”

The BoC says Canada’s real GDP growth was weaker than expected in the first quarter, with the economy contracting at an annual rate of 0.3%, compared with the 1.0% growth that it projected in April. Real gross domestic income (GDI) increased at an annual rate of 2.4% in the quarter, owing to a further 8.1% improvement in Canada’s terms of trade.

On a year-over-year basis, this real income measure is up nearly 4% as a result of the significant rise in the prices of many commodities that Canada produces, the BoC says. However, it appears Canadians are not spending it. The growth of household spending in Canada fell short of expectations in the first quarter, and the decrease in inventory investment was considerably larger than expected. This has led to cuts on large ticket items like automobiles, which have seen significant reductions in price.

These offsetting factors have also manifested themselves in the difference between core inflation and CPI. While CPI, which includes heavy weightings in food and energy, has taken off, the core inflation rate actually remains below the Bank’s 2% target.

Core inflation is projected to remain well in line with earlier expectations, averaging close to 1.5% through the third quarter of this year and rising to 2% in the second half of 2009. By the second half of 2009, the BoC expects Canada to break out of the low-growth/rising inflation deadlock. This growth is expected to coincide with a rebound in the U.S. economy and improvement in the global financial system, which it expects to stabilize by 2010.

“The Bank projects that the Canadian economy will grow by 1.4% this year, 2.4% in 2009 and 3.3% in 2010,” Carney says. “The emergence of excess supply in the economy should keep inflation below 2% through 2009. Both core and total inflation are projected to move up to 2% in 2010 as the economy moves back into balance.”

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Mark Noble