HIGHLIGHTS

• Bank of Canada keeps its rate unchanged …
• …but sets stage for rate hike on September 7th
• Positive economic news released in the U.S.

The past week was busy on both the economic and financial fronts with the release of positive economic data in both Canada and the United States, the announcement by the U.S. of the reopening of its border to Canadian cattle, and significant volatility in the Canadian dollar. However, the communiqué accompanying the Bank of Canada’s rate announcement on Tuesday and the Monetary Policy Report (MPR) Update released two days later were, without a doubt, the main highlights of the week.

While the Bank’s decision to leave the overnight rate unchanged at 2.50 per cent for a sixth consecutive Fixed Announcement Date (FAD) was highly anticipated, the accompanying statement caught financial markets by surprise. Prior to Tuesday’s FAD, the Bank had argued that “the economy was operating slightly below its full production capacity” and that a “reduction of monetary stimulus will be required over time”. However, Tuesday’s statement came with a considerable more hawkish tone, as the Bank stated that “some reduction in the amount of monetary stimulus will be required in the near term”. This means in simple terms that a 25-basis-points rate increase is in the cards at the next FAD on September 7th. Supported by this unexpectedly upbeat statement, the Canadian dollar soared and traded around 83 cents temporary before the greenback rallied later in the week on better-than-expected U.S. data.

While the Bank’s statement sent a powerful signal to financial markets that the overnight rate is poised to head higher soon, Thursday’s Bank of Canada MPR Update explained in more detail why the Bank is now on the verge of starting a tightening campaign. In particular, a variety of capacity indicators have led the Bank to believe that, on balance, “the Canadian economy is operating close to its production limits”:

• the Bank’s conventional measure of the output gap suggests that there is very little slack at the moment;

• the labour market is tight, as revealed by the record low 6.7-per-cent unemployment rate registered in June;

• More firms faced labour shortages and difficulty in meeting unexpected demand according to the latest Bank’s Business Outlook Survey;

• Statistics Canada’s measure of the capacity utilization rate for the manufacturing sector was at a record high in the first quarter of 2005.

In the MPR update, the Bank also revised up by a notch its real GDP forecast for 2005 from 2.6 per cent to 2.7 per cent, and noted “that the Canadian economy is continuing to adjust to global developments”. This week’s data releases add evidence to the view that the export side of the economy has begun to stabilize. While the trade surplus tumbled to $4 billion in May, the decline was largely the result of a demand-driven surge in imports, while exports only edged down. Meanwhile, after slumping in late 2004 and in early 2005, manufacturing shipments slipped by only 0.1 per cent in May, suggesting that the sector may be close to shift back into forward gear.

For next year, the Bank believes real GDP growth in Canada will accelerate to 3.3 per cent, identical to April’s MPR projection. As a result, the Bank sees the economy continuing to operate near its production capacity for the rest of 2005 and 2006 and expects inflation to rise gradually to 2 per cent target by the end of 2006. This implies that the current level of interest rates is too low. And given the 18-24 months lag in the transmission mechanism of monetary policy to prices, we believe that the overnight rate will be raised by 25 basis points at each of the September, October and December FADs, resulting in an overnight rate of 3.25 per cent by the end of 2005. Moreover, we expect the overnight rate to reach 4 per cent in 2005. While this represents a significant tightening in policy, it will still leave rates at historically low levels.

Prospects for Canada’s export sector received a boost this week on a few fronts. After the U.S. court of appeals dismissed the arguments by an American ranchers’ group that shipments of Canadian cows to the U.S. could spread mad cow disease, the U.S. Department of Agriculture’s plan to fully reopen the border to Canadian cattle is more likely to happen. However, hearings on a permanent injunction are set on July 27.

Moreover, economic data released south of the border contained good news. In particular, U.S. retail sales bounced back very strongly in May (1.7 per cent) and industrial production gained significant ground in June (0.9 per cent), as the manufacturing, mining and utilities sectors showed solid increases. Even if the domestic side of the U.S. economy remained strong, there are few signs of price pressures at all. In fact, core inflation data at the retail and wholesale level for June showed further signs of moderating price increases. In view of these positive developments, the Fed will likely continue to reduce the amount of monetary stimulus in the U.S. economy over the next few months, but only at a gradual pace. Speeches by Federal Greenspan to the U.S. Congress scheduled on Wednesday and Thursday will provide insights on how close the Fed may be to the end of its rate hiking cycle. In our view, look for the Fed to keep on tightening until the Fed funds rate reaches 4 per cent in early 2006.

Sébastien Lavoie, Economist
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