Thursday, September 25, 2008

RBC comments on Canada's Economy

Canada’s economy limps along in the second quarter

Canada’s economic growth reports have been disappointing, with real GDP contracting at a 0.8% annualized rate in the first quarter and eking out only a mild 0.3% annualized growth rate from April through June. Hiding beneath these soft overall growth numbers, however, Canada’s domestic economy remained firm. Final domestic demand growth averaged 2.2% during the six-month period, slower than 2007’s 4.2% pace but much stronger than the tepid growth rate for the overall economy.

Slower-than-expected housing reports and the sharp 55,000 job loss in July are supporting worries that the domestic economy’s growth momentum is starting to crack. However, August’s 15,200 job gain took some of the heat from these concerns because the report suggested that July’s sharp drop may have overstated the weakening in the labour market.

The market is priced for the Bank of Canada to take action and cut the policy rate to shore up the economy despite the fact that the headline inflation rate is running above the top end of the Bank of Canada’s target band. To be sure, the core measure remains secured below the mid-point of the Bank’s target band but, with a 3.4% headline inflation rate, policymakers will remain wary about a pick-up in inflation expectations.

In its September 3 policy statement, the Bank highlighted both upside and downside risks to the inflation/growth outlook, indicating an even-handed assessment of the risks. To be sure, the Bank pointed to some greater downside risks to growth emanating from a faltering U.S. economy while acknowledging that the hit to inflation from higher energy prices may not be as pronounced as was feared in July. However, the downside risks to growth are focused more on activity in 2009, while Canada’s "strong" domestic economy and global inflationary pressures continue to present a near-term upside risk to the medium- term inflation outlook.

This characterization suggests that the central bank will remain on the sidelines monitoring the economic data to see whether one or the other risk comes to dominate. Our forecast assumes a 3.00% overnight rate through the end of this year before being gradually raised in 2009 as the downside risks to growth ease.

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