Canadian Economic Highlights for Week 2 April 2011

• The Bank of Canada’s Business Outlook Survey indicated that the inflation expectations of businesses have turned upwards, while more firms appear to be facing increased capacity pressures. Our view on inflation and the direction on monetary policy remains unchanged. The increase in inflation expectations is largely linked to rising energy prices.
• Firms indicated that competitive pressures will limit their ability to pass cost increases onto consumer prices.
• A number of domestic demand indicators suggest inflation will not be a problem in the near-term. Nonetheless, slack in the Canadian economy is gradually being absorbed and a rebalancing of monetary policy will be needed, but the Bank of Canada can wait until July to start raising rates.

Canada – Between a Rock and a Soft Place

One of the key developments this week was a rate hike by the European Central Bank (ECB) in an effort to combat eadline inflation. At first glance, one would think that this week’s release of the Bank of Canada’s (BoC) closely watched Business Outlook Survey (BoS) indicates that the central bank should follow the ECB’s lead. The survey results showed that businesses expect food and energy price inflation to remain elevated, and headline inflation to accelerate. Meanwhile, the fact that some businesses are
having some difficulty meeting demand suggests that slack in the Canadian economy is being diminished. However, we find a number of reasons to believe that the BoC is not likely to follow the ECB in raising rates at next week’s fixed announcement date.

The ECB targets headline inflation, while the BoC puts considerable emphasis on core inflation, and is thus likely to look past rising food and energy prices. With Canadian core inflation of just 0.9% in February, the BoC does not appear pressed with an inflation problem.

First, a significant amount of slack still exists in the Canadian economy. While the share of firms experiencing some to significant difficulty meeting demand has turned up, its remains low by historical standards. What’s more, Canadian economic growth will likely moderate to below 3.0% in the second half of this year, helping to keep inflation pressures in check. The BoS indicated that while 40% of firms indicated some difficulty in meeting demand, businesses are less confident that the uptick in growth will be sustained through the rest of 2011. As a result, businesses have been shy to unlock unused excess capacity that still exists in the Canadian economy.

Second, while rising energy prices are impacting the bottom lines of Canadian businesses, the feed-through to Canadian core prices will be limited. Concerns over competition will limit how much of rising costs businesses will be able to pass onto consumer prices. Moreover, Canadian households will feel the pinch from rising food and energy prices. With the price of oil hitting U.S. $110 per barrel at the end of this week, these price pressures are unlikely to abate in the near future. This will put upward pressure on headline prices, but also leave less money in pockets for other items, which is a negative for core inflation.

Last but not least is the Canadian dollar, which rose to a three year high of U.S.$ 1.046 by weeks end. The strength in the Canadian dollar will dampen Canadian exports, constraining economic growth. It could also dampen prices for imported consumer goods. All of which helps to constrain inflation.

That’s all to say that the BoC has some leeway with monetary policy over the coming months. At next week’s fixed announcement date, and in the MPR, the BoC will highlight the improving economic backdrop, but is also likely to signal that they are not unduly worried about inflation. Indeed, economic growth has surpassed its January forecast by a large margin, and the performance in the labour market over the last six months has been relatively healthy. Despite a disappointing March, on a four-month moving average the labour market has added 28,000 jobs per month. This is consistent with healthy economic growth of 2.5-3.0%. The bottom line is that slack in the economy is being absorbed, but the BoC can wait until July before gradually tightening monetary policy from its current hyper accommodative stance.

Diana Petramala, Economist 416-982-6420

Courtesy of:
Marna Dueck
Mobile Mortgage Specialist
TD Canada Trust
Cell:  604 725 0284 or 780 918 3219
Pager:  1 866 767 5446
Fax:  604 541 0224

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