BANK OF CANADA HOLDS OVERNIGHT TARGET AT 0.25% AND NOTES POSITIVE PROSPECTS FOR LATTER-2009

Grant Bishop, Economist
September 2009

• Bank holds overnight target at 0.25%, reiterating
conditional commitment to hold interest rates until
Q2/2010.

• Notes prospects for better-than-expected rebound
during latter-2009 and expects return to inflation
target by mid-2011.

In its scheduled announcement, the Bank of Canada maintained the overnight target at 0.25%, consistent with its conditional commitment to maintain the rate at
its current effective lower bound until at least Q2/2010.

The announcement was largely a re-iteration of previous announcements, with certain minor changes. The Bank observed signs that recovery has commenced and deemed
that Canada’s growth in the second half of 2009 could be stronger than the Bank anticipated in its July Monetary Policy Report (MPR). Nonetheless, while a stronger-than expected rebound would represent an upside risk to the inflation
outlook, the Bank still views that, “as a consequence of operating at the effective lower bound, overall risks to its inflation projection are tilted slightly to the downside.”

That is, if prices weaken, monetary policy has limited room to manoeuver without moving to quantitative easing (QE). The Bank noted the factors supporting domestic demand in Canada, observing a rebound in confidence and firmer commodity prices, as well as stimulative policy and improving financial conditions. In particular, the Bank pointed to inventory adjustments and automotive production as positive indicators. While manufacturing inventories were still contracting as of June and inventory to- shipment ratios remained high, the pace of draw-down has slowed and manufacturing shipments appear to have stabilized. Motor vehicle production has rebounded from its nadir in May.



We will be upgrading our projections in our forthcoming Quarterly Economic Forecast and foresee positive growth in the latter half of 2009, slightly stronger than that forecasted by the Bank of Canada in their July MPR. However, we anticipate much more tepid recovery during 2010 and 2011. While the Bank expects a return of total CPI inflation to its 2% target in Q2/2011, our lower growth projection implies a prolonged negative output gap and continuing downward pressure on core prices. We do not foresee closure of the output gap until latter-2012. As a result, we project that the Bank will be more likely to go slow than to rapidly hike rates after its conditional commitment expires.

The Bank has flagged persistent strength of the loonie as a potential risk to growth in its last two announcements, as well as in speeches by Bank staff. A higher dollar could be a net drag on growth if it results from purely speculative inflows. However, if a higher dollar is in response to relative macroeconomic strength or rising commodity prices, the appreciation partially offsets upward pressures
on prices. In all of its announcements, the Bank has added the boilerplate that it “retains considerable flexibility” in the “conduct of monetary policy at low interest rates.”

However, we do not consider it at all likely that the Bank would intervene directly in the foreign exchange market or would undertake QE in direct response to a persistently high dollar. The Bank has made clear that any additional loosening in policy would be in response to a substantial downside deterioration of inflation against its baseline projection. That is, monetary policy responds to prices,
not the exchange rate. And, even if the dollar does place a drag on recovery, the Bank would be more likely to signal the maintenance of low interest rates for longer, rather than to move to QE.