Carol Lome - Broker

As expected, the Bank of Canada maintained the policy rate at 1.00% today. The tone of the discussion on the global outlook was broadly the same as in April with the global recovery proceeding and challenges to the outlook being offset by very stimulative financial conditions. Importantly the Bank highlighted that if the domestic "expansion continues and the current material excess supply in the economy is gradually absorbed, some of the considerable monetary policy stimulus currently in place will be eventually withdrawn." This is a more aggressive statement than in the previous rate decision press releases and the April Monetary Policy Report. Additionally the Bank highlighted that "greater momentum in household spending" may present an upside risk to inflation. In recent statements the Bank has tended to focus on the downside risks stemming from the strength of the Canadian dollar and commensurate decline in import prices as presenting downside risks to the inflation outlook. The mention of the upside risk in today's press statement underscores the Bank's assessment that policy stimulus will need to be pared back.

Yesterday's first quarter real GDP report showed the economy grew at a 3.9% annualized pace, the fastest since the first quarter of 2010. However the details of the report showed significant reliance on inventory building, no support from consumer spending and external trade acting as a drag on the pace of activity in the quarter. Business investment was the key source of strength for the economy in the first quarter, in line with the Bank of Canada's baseline view. However, some reversal of the inventory build along with some auto-related weakness is expected to moderate Q2 growth with RBC looking for 2.8% second quarter growth and the Bank expecting the rate to slow to 2%. To that end, the Bank forecasts that the supply disruptions will "restrain growth sharply" in the second quarter but expects this slowing to prove temporary.

Inflation however has been running hotter than the Bank's projection with the core rate starting the second quarter at 1.6% and the headline rate at 3.3%. To be sure, the Bank acknowledged that the headline rate the combination of high energy prices and the HST is likely to result in the rate holding above 3% in the near term. This is a change from its April statement that the rate would peak around 3% in the second quarter. Factors like spiking energy prices and the HST are forecast to fall out of the equation or at least moderate in the second half of the year resulting in the headline rate averaging about 2.5%. Today's statement indicates that the Bank still expects both the headline and core rates to converge at 2% in the middle of next year. In the near-term, the expected slippage in the pace of economic growth in the second quarter is likely to keep the Bank on the sidelines in order to ensure that the domestic economy does not maintain this softer growth path especially given the heighted global uncertainties. However as there is more clarity on how some of the key international issues are playing out combined with indications that the domestic economy reaccelerated in the summer months are likely to tee up a rate increase in September with subsequent hikes likely in the remaining two meetings of 2011. We are forecasting that the policy rate will end 2011 at 1.75%.

Article courtesy of RBC Economics - May 31st. 

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