June 15, 2007

• Stage set for 25bp hike in Canadian target interest rate next month
• Fed move unlikely

Economists aren’t so tech-savvy to think first of iPods when thinking about ‘i’ words. Safer bets, both at Scrabble and in anticipating what they mean, are the less hip but nonetheless oh so important words like inflation or intervention. Following the Reserve Bank of New Zealand’s intervention to help take some steam out of its currency by selling some NZ dollar reserves, this ‘i’ word prompted some chatter about whether the Bank of Canada (BoC) would view the recent surge in the Canadian dollar as diminishing the need for an interest rate hike. The currency might be on the radar, but it isn’t the primary concern of an inflation-targeting central bank like the BoC, and rightly so.

Despite protracted difficulties in the forestry and some manufacturing industries, the Canadian economy as a whole continues to chug along quite nicely. Real GDP growth is running above the BoC’s estimate of long-term trend growth of 2.8%. When the economy is in that sense ‘overstretched’, upward price pressures tend to develop.

Despite Monday’s news of better-than-expected 2.8% annualized productivity growth for the first quarter, downward revisions to productivity in the previous two quarters along with a strong 3% gain in unit labor costs will do nothing to alleviate the BoC’s concerns over the outlook for inflation. Neither will the April manufacturing shipments report which, under a headline 0.6% decline, showed volumes increasing for the third month in a row, bringing the year-over-year change into positive territory.

Tweaking time

In fact quite the contrary has happened, and the stage is now set for a 25 basis points interest rate hike at the BoC’s upcoming Fixed-Announcement Date on July 10th. A reputable inflation rate targeting central bank like the BoC cannot, and will not, let core inflation run significantly above target for months on end. From housing to energy, from commodities to wages, demand-pull inflation hasn’t let up and doesn’t seem likely to do so on its own. New and resale home prices, energy prices, base metals prices, and agricultural commodities prices are all in double-digit territory on a year-over-year basis, and have been for some time.

Hence the need for the BoC to gently tap on the economy’s brake by increasing near-term borrowing costs through its target overnight rate. In a speech delivered this week on the monetary policy implications of demographics, BoC Governor Dodge all but confirmed this.

Some lip service was paid to the surging Canadian dollar and the possible substitute role it can play in helping slow down some sectors of the economy as well as price growth, but any BoC attempt to re-align the value of the currency vis-à-vis the U.S. dollar is, to put it lightly, improbable and, in any case, innefective. The export-oriented industries that are commodity-related are benefiting from enough of a surge in commodity prices to offset the otherwise large drop in their Canadian dollar earnings margins.

Furthermore, the high loonie will not necessarily temper inflation. Lower import prices don’t trickle down to lower consumer prices quickly, or completely. They tend to lag changes in the value of the currency, and not match them one for one. Many firms adjust their margins to compensate for losses incurred when the currency’s value was much weaker. All told, even the recent 10% climb in the Canadian dollar since March is unlikely to sway the BoC.

Comfortable on the fence

Meanwhile, in the U.S., a much anticipated CPI report for May provided further evidence that core inflation is gradually cooling. Year-over-year core CPI was running at 2.2% in May. More importantly, at 1.6%, the annualized 3-month average is down a full percentage point from that observed in mid-Q1. Although the Federal Reserve doesn’t explicitly target the core CPI, it does have an implicit comfort zone of 2.0-2.5%. However, we don’t think that Bernanke & Company are itching to pull the trigger either way for some time to come. The fed funds rate is likely to remain unchanged for the remainder of this year.

First, inflation seems to be cooling with no need to tighten policy. Second, the economy, while still growing at a sub-par rate, is doing reasonably well outside of residential construction activity and related sub-prime mortgage market woes. This was highlighted by an advanced retail sales report on Wednesday. Indeed, overall retail sales for May were up 1.4% and up 1.0% even after excluding auto and gasoline sales. For the most part, American consumers are shrugging off higher gas prices and, in some regions, declining home values. Furthermore, manufacturing and non-manufacturing sector activity indicators like the ISM indices are signalling modest economic expansion going forward.

With this backdrop of a resilient domestic U.S. economy and a fairly strong global growth outlook, markets have finally heeded the call that central banks do what central banks do, which is make sure inflation doesn’t get out of hand. As it should be, a tightening bias is on most central bank’s menus around the world, and the U.S. isn’t immune to that shift. But unlike its international counterparts, most economic risks are still to the downside for the U.S., alongside easing inflationary pressures suggesting rate hikes are not in the pipeline. This upcoming Wednesday, look to our Quarterly Economic Forecast for an updated and detailed financial and economic outlook.

Pascal Gauthier, Economist
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