20 Jul

Bank of Canada ups overnight rate by 25 basis points and retains cautious stance


Posted by: Chris Cavaghan

The Bank of Canada boosted the overnight rate by 25 basis points (bps) to 0.75% this morning and reiterated that the timing of further reductions in policy stimulus will be contingent on developments both within and outside of Canada. The rate hike was widely expected by financial markets. The Bank characterized domestic economic developments as “unfolding largely as expected” although policymakers trimmed back forecasts for 2010 and 2011 GDP growth while boosting 2012. The global recovery was characterized as proceeding although the need for balance sheet repair by households, banks and governments will likely “temper the pace of global growth” relative to the Bank’s previous forecast. The central bank noted that the policy response to the European sovereign-debt crisis has eased pressures in financial markets, although the implied fiscal restraint will act to slow growth.

Canada’s economic forecasts were altered, so 2010 growth is now forecasted at 3.5% from 3.7%, 2011 at 2.9% from 3.1% and 2012 at 2.2% from 1.9%. As a result, the Bank now expects the economy to return to full capacity at the end of 2011, rather than in the second quarter as was forecasted in April. The forecast changes reflect an updated forecast for the global economy and a slower expected profile for Canadian consumer spending. The Bank now expects business investment and net exports to make “a relatively larger contribution to growth.” More details will be available on Thursday, July 22, 2010 with the release of the Bank’s Monetary Policy Report.

The inflation profile is little changed according to the statement, with both the headline and core measures forecasted to “remain near 2% during the projection period.” The Bank said that it will, “look through the transitory effects on inflation” from the implementation of the HST in Ontario and BC.

Once again, the Bank highlighted that there is significant uncertainty about the economic outlook and that, even with the two 25 bps increases in the overnight rate, there remains “considerable monetary stimulus in place.” 

Recent Canadian economic reports have been a mixed bag, with exports, imports and manufacturing sales all posting gains in May while housing activity slowed from the blistering pace earlier in the year. Sifting through these reports, we remain comfortable with our forecast that the economy grew at a 3.0% annualized pace in the second quarter of 2010. Importantly, the data signals that the domestic economy has not buckled under the strains created by the European sovereign-debt crisis and the weaker tone in some of the U.S. reports. While the data point to GDP growth in the second quarter running at a pace that is one-half of the 6.1% surge in the first quarter of 2010, the near-record pop in employment in the quarter (226,600 jobs were created in April to June) is consistent with the economy maintaining its solid growth momentum. We forecast growth at an above-potential rate in the second half of the year with the unemployment rate gradually to decline. 

The Bank’s summer Business Outlook Survey, released last week, suggested that pressures on capacity are starting to emerge and an increasing number of businesses are ready to up prices. With the core inflation rate already running close to the mid-point of the 1% to 3% target range, we expect that policymakers will want to withdraw stimulus gradually to ensure that price pressures remain on target. In our minds, the domestic data are consistent with the Bank raising the overnight rate to 1% at the September fixed-action date and 1.25% by the end of the year.  External developments related to Europe’s sovereign-debt crisis and concerns about the pace of U.S. growth remain a risk to Canada’s growth outlook, thereby opening the door for the Bank of Canada stepping to the sidelines to assess the effect of its rate hikes later this year. Our base case forecast, however, is that the strength in Canada’s domestic economy will persist, meaning that the current “emergency” level of rates is no longer warranted. Our forecast is that the overnight rate will be 1.25% at the end of 2010 and 2.75% at the end of 2011, higher than the rates implied by the futures market.  

Dawn Desjardins, Assistant Chief Economist, RBC Economics