Bank Of Canada Warns About 'Some Modest Withdrawal' Of Stimulus

As widely expected, the Bank of Canada left interest rates unchanged at 1.00% but it now says that "some modest withdrawal" of the present considerable stimulus may become appropriate.

The BoC also provided a sneak peek of its Monetary Policy Report due tomorrow by giving some information about its latest growth forecasts. The Bank acknowledges that the US economy has been "slightly stronger" than expected. The outlook for Europe was a bit better than first thought, with the BoC now anticipating that the eurozone will get out of recession in the second half of 2012. Elevated oil prices remain a risk to the outlook.

For Canada, the GDP growth forecast for 2012 was revised up four ticks to 2.4%, while 2013 was revised down four ticks to 2.4%. The call for 2014 is for growth of 2.2%. With net exports struggling under the weight of a strong Canadian dollar, the BoC expects domestic demand to account for "almost all of Canada's economic growth over the projection horizon." The 2012 revision was widely expected given StatCan's sharp upward revision of Q3 2011 and Q4 growth that ended up close to the BoC's estimate, the combination of which meant that we started 2012 at a higher base than what the BoC had anticipated back in January.

All told, the economy is operating with less slack than previously assumed and the BoC indeed acknowledged that by stating that the output gap is now expected to close in the first half of 2013 (versus Q3 2013 in January's MPR). With the smaller negative output gap, inflation is now seen to be a bit hotter than estimated back in January. Both headline and core CPI are now expected to be around 2% "over the balance of the projection horizon" (versus January's forecast which showed less than 2% towards end of 2012).

Bottom Line

After the presentation of the federal budget, it's becoming apparent that fiscal drag isn't likely to be as large as first feared, giving the BoC more room for rate action. Moreover, with the government deciding not to intervene with new rules to cool down the arguably overheating housing market, the onus is now on the BoC to address, on its own, the problem of household debt accumulation which it views as the "biggest domestic risk."

Overall, the press release was more upbeat, given the improved economic outlook both at home and abroad. In light of the closure of the output gap in the first half of 2013 the BoC is now saying that "some modest withdrawal" of the present considerable stimulus may become appropriate. Although the BoC is not providing any guidance of the timing of such moves, the wording "may become" suggests that rate hikes, while not imminent, are not as far down the line as markets were anticipating. So the possibility of a rate hike this year cannot be entirely discarded. That said, given our own forecast about the European situation (-1.5% growth for 2012) and risks to global growth in general, we see the BoC raising rates only in 2013 but before mid-year.

Here Is The Press Release (sections highlighted by BoC):

The Bank of Canada today announced that it is maintaining its target for the overnight rate at 1 per cent. The Bank Rate is correspondingly 1 1/4 per cent and the deposit rate is 3/4 per cent.

The profile for global economic growth has improved since the Bank released its January Monetary Policy Report (MPR). Europe is expected to emerge slowly from recession in the second half of 2012, although the risks around this outlook remain high. The profile for U.S. growth is slightly stronger, reflecting the balance of somewhat improved labour markets, financial conditions and confidence on the one hand, and emerging fiscal consolidation and ongoing household deleveraging on the other.

Economic activity in emerging-market economies is expected to moderate to a still-robust pace over the projection horizon, supported by an easing of macroeconomic policies. Improved global economic prospects, supply disruptions and geopolitical risks have kept commodity prices elevated. In particular, the international price of oil has risen further and is now considerably higher than that received by Canadian producers. If sustained, these oil price developments could dampen the improvement in economic momentum.

Overall, economic momentum in Canada is slightly firmer than the Bank had expected in January. The external headwinds facing Canada have abated somewhat, with the U.S. recovery more resilient and financial conditions more supportive than previously anticipated. As a result, business and household confidence are improving faster than forecast in January. The Bank projects that private domestic demand will account for almost all of Canada’s economic growth over the projection horizon.

Household spending is expected to remain high relative to GDP as households add to their debt burden, which remains the biggest domestic risk. Business investment is projected to remain robust, reflecting solid balance sheets, very favourable credit conditions, continuing strong terms of trade and heightened competitive pressures. The contribution of government spending to growth is expected to be quite modest over the projection horizon, in line with recent federal and provincial budgets. The recovery in net exports is likely to remain weak in light of modest external demand and ongoing competitiveness challenges, including the persistent strength of the Canadian dollar.

As a result of this reduced slack and higher gasoline prices, the profile for inflation is expected to be somewhat firmer than anticipated in January. After moderating this quarter, total CPI inflation is expected, along with core inflation, to be around 2 per cent over the balance of the projection horizon as the economy reaches its production potential, the growth of labour compensation remains moderate, and inflation expectations stay well-anchored.

Reflecting all of these factors, the Bank has decided to maintain the target for the overnight rate at 1 per cent. In light of the reduced slack in the economy and firmer underlying inflation, some modest withdrawal of the present considerable monetary policy stimulus may become appropriate, consistent with achieving the 2 per cent inflation target over the medium term. The timing and degree of any such withdrawal will be weighed carefully against domestic and global economic developments.