Bank of Canada to Bide It's Time

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Monetary Policy Monitor TD Economicswww.td.com/economics

April 8, 2011

BANK OF CANADA TO BIDE ITS TIME

TILL SUMMERTIME

HIGHLIGHTS

TheBankofCanadawillkeepits

policyinterestrateunchanged

at 1.00% nextweek andwill

strikea cautiously optimistic

toneintheaccompanyingcom-

muniqu.

ThereleaseoftheAprilMPRwill

contrastamorerobustoutlook

foreconomicgrowthwithabe-

nignbackdropforinflation.We

expectthesteadyabsorptionof

sparecapacitywillprompttheBanktomovenextinJulyand

taketheovernightrateto2.00%

bytheendof2011.

Many central banks the world over are torn between the need to nurture still-

fragile economic recoveries and the fear of falling behind the curve to contain grow-

ing inationary pressure. Not so for the Bank of Canada who is facing the enviable

combination of robust economic growth and remarkably benign ination. While

the steady absorption of spare capacity will eventually necessitate the withdrawal of

monetary stimulus, there is no urgency to act next week. As a result, the overnigh

rate will almost certainly be left unchanged at 1.00% on Tuesday. Meanwhile

both the communiqu accompanying the decision and the Monetary Policy Report

(MPR) released the following day are expected to balance cautious optimism with

a laundry list of pre-dominantly downside

risks littering the road

ahead.

In contrast to the

recent behaviour of

the marketwhich

had priced out hikes

until well into the sec-

ond half of the year

following the tragedy

in Japan and the riseof geopolitical ten-

sions in the Middle

East and North Af-

ricathe tone taken

by the Bank next week

will likely solidify ex-

pectations for an earlier move. However, the Bank is not expected to be sufciently

hawkish to set the stage for an increase in the overnight rate in May. Instead, we

reiterate our long-standing call for the next rate hike to occur in July and for a

year-end target of 2.00%.

GrowthOutlookPremisedonPuttingAmericatoWork

In the communiqu accompanying the March Fixed Announcement Date (FAD)

the Bank acknowledged that the recovery in Canada was proceeding faster than

they had forecast in the January MPR. The Bank also cited more evidence of a

rebalancing in the drivers of economic growth away from domestic demand and

towards net exports. These are encouraging developments, and they conrm our

suspicion that the forecast presented in the January MPR was too conservative in

its estimation of the impact that the scal stimulus in the United States announced

last December would have on the Canadian economy. Real GDP growth in 2010Q4

outstripped the Banks forecast by a full percentage point and the rst quarter of

2011 is shaping up to do the same. Renewed strength in exports is a major con-

tributor to both quarters.

DavidTulk

ChiefCanadaMacroStrategist

TDSecurities

416-983-0445

TheBankofCanada:HowWeSeeItInflation

USDCAD

US Economic

GrowthFinancial Stability

EventRisk

April

May

July

September

CurrentOutlook

HikeNow

Each web corresponds to a Fixed Announcement Date where each variable

implies how many meeting dates away the variable is from a tightening in

policy. A move towards the origin corresponds to an earlier hike.


2/6

Monetary Policy MonitorApril 8, 2011

TD Economicswww.td.com/economics

2

Looking out over the balance of the year, the key to a

sustainable contribution from Canadas export sector is a

recovery in the US labour market. Recall that at the March

FAD (where US activity was described as solidifying but

still supported by stimulus) the labour market had recentlydisappointed the market by creating just 36K jobs in Janu-

ary while revealing a depressing set of benchmark revi-

sions. Since that time, the labour market appears to have

nally turned a corner, stringing together several months of

respectable job gains. With corporate prots auguring for

an accelerated pace of hiring, the Bank is likely to have a

greater condence that the wider economic recovery will

be sustained in 2012.

The rebalancing in the drivers of Canadian economic

growth also implies a slower pace of domestic demand,

which will also support net exports through weaker imports.

Although the Bank conceded that consumer spending re-

mains quite robust, they expect a deceleration to a pace more

in line with income growth. While bank lending has begun

to moderate, the renewed strength observed in the labour

market will drive wage gains that in turn will support spend-

ing. When combined with the positive terms of trade shock

provided by rising commodity prices, domestic demand may

not moderate as quickly as the Bank had initially thought.

Weaving together these various threads reveals a stron-

ger outlook for Canadian growth than what the Bank had

presented in the January MPR. While we expect a sizable

upwards revision to the near-term outlook for real GDP

growth, it remains an open question of how much activity

will be pulled forward from the future. If forecasted growth

in 2012 remains in the ballpark of the 2.8% forecast in Janu-

ary, the Bank is far more likely to embark on a sustained

sequence of rate hikes, which in our view, will begin in July

CaveatstoGrowthareBothTransientandPersistent

There are two important caveats to the growth outlook

The rst is the disruption to the global supply chain caused

by the earthquake in Japan. The trading relationship betweenthe two countries is relatively small (Canadian exports and

imports to and from Japan represent 2.3% and 2.5% of their

respective totals) and rms will have the ability to meet

demand over the very short run by drawing down existing

inventories. It is very difcult to predict exactly how long

the supply disruption will last and already a shortage of

parts primarily in the auto industry have caused factories in

Canada to scale back production. It is expected that once

the electricity and transportation infrastructure in Japan is

restored, exports will rebound and the net impact will be a

redistribution of activity between quarters. From the per-spective of the Bank, these developments will contribute

additional volatility to the quarterly prole for real GDP

growth, but is unlikely to impact the timing and magnitude

of rate hikes.

The second and far more persistent caveat to the growth

outlook is the currency. Since the Bank lifted its policy

rate off of the 25 basis point oor last June, the Canadian

dollar has consistently run ahead of what was incorporated

into each MPR by several cents. By providing an implici

degree of tightening, the Canadian dollar takes some of the

pressure off of the Bank to aggressively normalize interesrates. However, the relative stability in the currency reduces

the uncertainty facing exporters and makes it comparatively

easier to adapt to its strength when set against a cyclically

stronger US economy.

While the currency is forecast to remain well supported

over the next two years, the risks are stacking up to the

downside. In recent weeks, the Canadian dollar has mirrored

the performance of equities and equity market volatility both

of which are susceptible to global event risk and the targeted

end of QE2 looming at the end of June. At a minimum i

is expected that the Bank will cite the persistent strength

U.S. CORPORATE PROFITS AND EMPLOYMENT

-6

-4

-2

0

2

4

6

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

-40

-30

-20

-10

0

10

20

30

40

50

Corporate Profit (Led 4 Quarters, RHS)

Employment (LHS)

Y/Y % Chg. Y/Y % Chg.

Source: Statistics Canada

Q1-11 Q2-11 Q3-11 Q4-11 2011 2012

TD 3.8 3.2 2.8 2.6 3.0 2.5

BoC 2.5 2.8 3.0 3.0 2.4 2.8

Consensus 3.3 3.1 3.0 2.9 3.0 2.9

CanadianRealGDPForecast(AnnualizedPercentChange)

Source: Bloomberg, Bank of Canada, TD Economics


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3

in the currency as a factor impeding growth next week but

when facing a terms of trade shock, the positive contribu-

tion to economic growth and income will dominate. But

as a warning to the market, any move to push the currency

higher in anticipation of hikes will prove to be self-defeating

as the Bank is just as likely to stand to the side and let the

currency slow economic growth and tame ination.

PlayingWithPotentialGrowthtoCureCapacity

ConstraintsandAnchorInation

With the outlook for economic growth stronger than theBank had previously forecast, there is a risk that the output

gap could close a full year earlier than the end of 2012 cur-

rently expected. However, in the April MPR the Bank will

revisit its forecast for potential output and there is a denite

possibility that it could be revised higher (we outlined the

case in a recent research note availablehere). The net impact

of an upwards revision to both actual and potential output

will correspond to the closing of the output gap anywhere

from the middle to the end of 2012.

Although the output gap may close somewhat faster than

the Bank had initially previously forecast, the outlook forination continues to unfold largely as outlined in the Janu-

ary MPR. Headline ination does remain subject to higher

commodity prices (note the price of crude oil is nearly $20

higher today than in January) but for the moment wider

price pressures remain subdued. If anything, the weakness

observed in core ination in February could introduce a very

modest downside risk to the Q1 forecast of 1.4%. It is this

overarching theme of a very benign backdrop for ination

that provides the most compelling piece of evidence keep-

ing the Bank on the sidelines next week. Looking further

into the future, we expect that the downright anaemic 0.9%

reading on core ination observed in February will prove to

be the cyclical trough and that price pressures will gradu

ally build in tandem with a dwindling overhang of excess

capacity.

Against a backdrop of a smaller cushion of disination

ary slack, the prospect of higher ination expectations wil

present a challenge to the Bank. It is telling that in the

communiqu accompanying the last FAD, the reference tha

ination expectations were well anchored was dropped. A

that time, 10 year breakeven ination had jumped by almos

10 basis points and has since moved higher by almost 25

basis points. In level terms, breakevens are currently in

the neighbourhood last observed in April 2010 when the

Bank abandoned its conditional commitment as a precurso

to lifting the overnight rate off of the 25 basis point oor

This move was corroborated by the quarterly release of theBusiness Outlook Survey (BOS) which noted that the pro

portion of respondents expecting ination rose to the uppe

end of the 1-3% target range. The increase in commodity

prices largely drove this expectation higher, however, with

rapidly diminishing economic slack, we expect the Bank to

assume a less benign stance on the risk to future ination.

The importance the Bank places on ination expecta

tions is well-known. In a recent speech, Governor Carney

linked the theme of what he described as a secular rise in

commodity prices to the conduct of monetary policy. In

particular Carney reiterated the view that it is paramounthat monetary policy everywhere acts to ensure that ina

tion expectations remain in line with medium-term policy

objectives. In the context of the Canadian outlook, evi

dence of rising ination expectations will require that the

Bank remain vigilant and be prepared to act decisively in

the second half of the year.

CANADIAN DOLLAR VERSUS BANK OF CANADA

FORECAST

0.93

0.95

0.97

0.99

1.01

1.03

1.05

Jul-10 Aug-10 Sep-10 Nov-10 Dec-10 Jan-11 Mar-11

July MPR

Oct MPR

Jan MPR

US$/C$

Source: Bank of Canada, TD Securities

10-YEAR CANADIAN BREAKEVEN INFLATION

1.8

1.9

2.0

2.1

2.2

2.3

2.4

2.5

2.6

Jan-10 Mar-10 May-10 Aug-10 Oct-10 Dec-10 Mar-11

March FAD

April 2010

FAD

Percent

Source: Bloomberg
https://www.tdsresearch.com/currency-rates/viewEmailFile.action?eKey=LXC4N0SZG1FBJWV9Z1SHBNFVNhttps://www.tdsresearch.com/currency-rates/viewEmailFile.action?eKey=LXC4N0SZG1FBJWV9Z1SHBNFVNhttps://www.tdsresearch.com/currency-rates/viewEmailFile.action?eKey=LXC4N0SZG1FBJWV9Z1SHBNFVN


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INFLATION MEASURES

PRODUCT MARKET

LABOUR MARKET

CANADIANCONSUMERPRICEINDEX(CPI)

-2

-1

0

1

2

3

4

2006 2007 2008 2009 2010

-2

-1

0

1

2

3

4Y/Y % Chg.

Source: Statistics Canada/Haver Analytics

CPI: All Items

Bank of Canada

Core CPI ex. 8 most volatile

items & indirect taxes

Midpoint of

Bank of Canada's

Target Band

-4

-2

0

2

4

6

1990 1994 1998 2002 2006 2010

-4

-2

0

2

4

6Y/Y % Chg.


GDP Deflator

Personal Consumption

Deflator

CANADIANGROSSDOMESTICPRODUCT(GDP)

AND PERSONAL CONSUMPTION DEFLATORS

-5

-4

-3

-2

-1

0

1

2

3

1992 1996 2000 2004 2008 2012

Full Capacity Excess Demand

Excess

Supply

CANADA'S OUTPUT GAP

ActualRealGDPLessPotentialRealGDP%

Forecast by TD Economics as at March 2011

Source: TD Economics, Statistics Canada, Bank of Canada

Forecast64

68

72

76

80

84

88

1993 1997 2001 2005 2009

0.4

0.5

0.6

0.7

0.8

0.9

1.0%

* Total industry excluding aerospace products and parts


Ratio

Capacity Utilization Rate (lhs)

Unfilled Orders-to-Shipments

Ratio (rhs)

CANADIAN CAPACITY UTILIZATION RATE AND

UNFILLED ORDERS-TO-SHIPMENTS RATIO*

-3

-2

-1

0

1

2

3

4

5

1991 1994 1997 2000 2003 2006 2009

5

6

7

8

9

10

11

12

13

CANADIAN EMPLOYMENT AND UNEMPLOYMENT RATES

%


Unemployment Rate

(rhs)

Y/Y % Chg.

Employment

(lhs)

SKILLED LABOUR SHORTAGE IN CANADA

0

10

20

30

40

50

60

70

2000 2002 2004 2006 2008 2010

% of firms

Source: Bank of Canada/Haver Analytics


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5

WAGES,COSTSANDREALESTATE

INFLATION EXPECTATIONS

0

1

2

3

4

5

1998 2001 2004 2007 2010

Y/Y % Chg.


AVERAGE HOURLY EARNINGS OF PERMANENT EMPLOYEES CANADIAN UNIT LABOUR COSTS

-6

-4

-2

0

2

4

6

8

1990 1994 1998 2002 2006 2010

Y/Y % Chg.


-60

-40

-20

0

20

40

60

1995 1998 2001 2004 2007 2010

-60

-40

-20

0

20

40

60

BANK OF CANADA COMMODITY PRICE INDICES

Y/Y % Chg.

Total excl. energy

Total

Source: Bank of Canada/Haver Analytics

HOUSING PRICE INDICES

-15

-10

-5

0

5

10

15

20

25

1993 1997 2001 2005 2009

-15

-10

-5

0

5

10

15

20

25

Y/Y % Chg.

Source: CREA, Statistics Canada

New

Resale

0

10

20

30

40

50

60

7080

90

2004 2005 2006 2007 2008 2009 2010 2011

Per cent of firms expecting inflation to be above 3%

Per cent of firms expecting inflation to be 2-3%

Source: Bank of Canada

INFLATION EXPECTATIONS - CANADIAN FIRMS

%

0

1

2

3

4

5

1995 1998 2001 2004 2007 2010

CANADIAN LONG-TERM GOVERNMENT BOND YIELD -

CONVENTIONAL MINUS REAL RETURN

Source: Bank of Canada

%


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This reportis provided by TD Economicsfor customers of TD Bank Group. It is for information purposes only and may not be appropriatefor other purposes. The report does not provide material information about the business and affairs of TD Bank Group and the members oTD Economics are not spokespersons for TD Bank Group with respect to its business and affairs. The information contained in this reporhas been drawn from sources believed to be reliable, but is not guaranteed to be accurate or complete. The report contains economicanalysis and views, including about future economic and nancial markets performance. These are based on certain assumptions and other

factors, and are subject to inherent risks and uncertainties. The actual outcome may be materially different. The Toronto-Dominion Bankand its afliates and related entities that comprise TD Bank Group are not liable for any errors or omissions in the information, analysis o

views contained in this report, or for any loss or damage suffered.

Bank of Canada to Bide It's Time

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