BoC Revises July Monetary Policy Report Down

Following yesterday’s preamble, the Bank of Canada provided details about its downwardly revised outlook in the Monetary Policy Report. The Bank’s dovish tone about the global economy was supported by the trimming of its global growth forecasts for this year and 2013 to 3.1% (from 3.2% and 3.4% respectively in April's MPR). Despite yesterday's message that developments point to a "renewed contraction" for the eurozone, the BoC maintained its forecast of -0.6% for the zone's 2012 growth, while cutting half a point for 2013 growth to 0.3% (from 0.8%). China’s growth forecast was cut to 7.8% from 8.1% for 2012 and to 7.8% for 2013 (trimmed by two ticks).

For the US, the recent string of weak data prompted the BoC to lower its growth forecast for 2012 to 1.9% (from 2.3% previously). The BoC still sees a large fiscal drag, chopping 1% off GDP this year and 1.5% off in 2013 (versus April's assumptions of -1% and -2.5% respectively). Even with a smaller fiscal drag than previously assumed for 2013, the growth call for that year is pared four ticks to 2.1%.

For Canada, in addition to adjusting for its half point miss in Q1 of this year, the BoC lowered its growth forecasts for all quarters of 2012 as follows: 1.8% for Q2 (versus 2.5% previously), 2.0% for Q3 (versus 2.4% previously) and 2.3% for Q4 (versus 2.5% previously). That left 2012 growth at 2.1%, a three-tick downgrade from last April’s forecast. The BoC has cut its 2012 forecasts for consumption, investment and government (the latter now turns into a drag to GDP), while raising marginally the contribution of housing. Trade’s contribution to 2012 GDP increases but only because of weaker imports.

For 2013, the growth call was trimmed one tick to 2.3%, as a weaker 2012 handoff and a softer Q1 growth more than offset the impact of upgrades for subsequent quarters. Here, the BoC upgraded the contribution of government and business investment, but those were offset by softer consumption and housing.

Despite the disappointing performance of final domestic demand in recent quarters, the BoC is still counting on it to power the economy forward (+1.7% this year and +2.3% next year). The Bank left its forecast unchanged for the potential output growth at 2% for this year and 2.1% for 2013. The output gap at the end of Q2 was gauged at 0.4% below capacity (although the BoC's conventional measure of the gap is at -0.5%). That's larger than the Bank anticipated back in April, which explains why the timeline for the output gap to close has been pushed to the second half of 2013 (versus first half of 2013 in April's MPR).

With the economy being further away from potential than initially thought, and the lower assumed Brent oil price forecasts (latter tends to affect domestic gasoline prices), inflation forecasts have been revised down substantially. Headline CPI is now expected to be "noticeably below" the 2% target over the next year. Headline CPI is expected to average 1.2% in Q3 this year (versus 2.2% in April's forecast) and only go back to 2% in the second half of 2013. Core CPI is seen to average roughly 2% through the forecast horizon.

Bottom line:
The downward revisions to Canadian GDP were quite substantial, with the BoC undoing most of its April upgrades. So much so that the Canadian growth profile (2.1% for 2012 and 2.3% for 2013) is now arguably worse than it was even in last January's MPR when there was no tightening bias (latter had growth of 2.0% for 2012 and 2.8% for 2013). Yet, the BoC decided to maintain, in July's statement, the hawkish sentence that it introduced in April's MPR, i.e. "some modest withdrawal of the present considerable stimulus may become appropriate." Why have a tightening bias in July and not in January when the outlook wasn't as bad then? Perhaps it's a case of leaning forward to prevent slipping back ― the BoC may have decided to keep the tightening bias in July to counter expectations of rate cuts by markets.

Indeed, with the output gap remaining open until the second half of 2013, and inflation staying below the BoC's target, its understandable why markets would want to price in rate cuts. That seems to have worked by the looks of the subdued market reaction yesterday. The BoC remains concerned about household debt accumulation and perhaps it wants to remind markets that it remains vigilant about that risk. That said, by opting to keep the tightening bias, the BoC may be sacrificing growth by adding fuel to the Canadian dollar which has already proved more resilient than other commodity currencies in this "risk off" environment.