OTTAWA — The Bank of Canada kept its policy rate of 1% unchanged Tuesday while boosting its growth outlook for 2011 by a half-percentage point and signalling economic slack will shrink faster than anticipated.
The pace of price increases is also expected to pick up, with headline inflation hitting as high as 3% this quarter on temporary factors such as higher energy prices before converging to the central bank’s target of 2% in mid-2012 – or six months earlier than previously anticipated.
But the Bank of Canada warned “persistent” strength in the Canadian dollar “could create even greater headwinds” for the economy as it dampens export growth and inflationary pressure.
This rate decision ties in all the economic developments since the last policy statement on March 1 – from the earthquake and subsequent nuclear crisis in Japan to continued geopolitical unrest in North Africa to stellar Canadian data. The statement attempted to strike a balance between positive and negative developments, and offered no hint that the Bank of Canada, led by governor Mark Carney, is ready to pull the rate-hike trigger at its next policy decision on May 31. The decision to stand pat Tuesday was widely anticipated by markets.
The better-than-expected economic indicators, coupled with a global recovery that’s becoming “more firmly entrenched,” prompted the central bank to revise upward its outlook for 2011 real GDP expansion to 2.9% from its previous 2.4% call in January. On Monday, the International Monetary Fund also pushed up by 50 basis points its estimate for Canadian economic growth this year, to 2.8%. For 2012, the central bank anticipates 2.6% GDP expansion, slightly below its previous 2.8% forecast.
“Aggregate demand is rebalancing toward business investment and net exports, and away from government and household expenditures,” the central bank said.
“The bank expects business investment to continue to rise rapidly and the growth of consumer spending to evolve broadly in line with that of personable disposable income – although higher terms of trade and wealth are likely to support a slightly stronger profile” than previously expected.
As for net exports, now a key driver of economic activity, the central bank raised a red flag, saying the recent improvement “is expected to be further restrained by ongoing competitiveness challenges, which have been reinforced by the recent strength of the Canadian dollar.”
The continued strength in the loonie, which has traded above the US$1.04 mark for the better part of a week, “could create even greater headwinds for the Canadian economy, putting additional downward pressure on inflation through weaker-than-expected net exports and larger declines in import prices.”
The Canadian dollar has gained against its U.S. peer on stronger commodity and stock prices, as well as a selloff of the U.S. currency over concerns about Washington’s willingness to tackle its fiscal morass.
Entering Tuesday’s decision, fixed-income strategists said they would focus on what the central bank had to say about the amount of spare capacity in the economy, otherwise referred to as the output gap.
Given the improved economic outlook, the central bank said it expects economic slack to be fully absorbed by the middle of 2012, or two quarters earlier than anticipated. And in this statement, the bank described spare capacity as “material excess supply,” as opposed to “significant excess supply” as it did previously.
Economists suggest the central bank generally would like to get its policy rate to a so-called neutral level by the time economic slack dissipates.
Shrinking spare capacity also triggers inflationary pressure, and the central bank – which is mandated to set its rate to achieve and maintain 2% inflation – said the run-up in food and energy prices were “contributing to the emergence of broader global inflationary pressures.”
Canada headline inflation is set to 3% in the coming months on higher energy prices and then drift toward the 2% target by mid-2012. And while core inflation, which strips out volatile items such as food and gas, hit a record low in March of 0.9%, the central bank said it would gradually rise to 2% mid-2012 as slack is absorbed, wage growth stays modest and productivity “recovers.”
