Canadian Rate Watch Heats Up

 |  Includes: EWC, FXC
by: Roger S. Conrad

The Bank of Canada (BoC) kept its benchmark interest rate at 0.25 percent yesterday and reiterated its “conditional commitment” to keep it there until the end of the second quarter. But amid more evidence that the global recovery is strengthening, the central bank sent the strongest signals yet that July 20, 2010, will mark the start of a modest rate-hiking cycle up north.

The BoC was more precise with its inflation forecast and said again that the pace of global growth is stronger than the central bank estimated in the October Monetary Policy Report. At the same time, Canada’s central bank acknowledged that “the recovery continues to depend on exceptional monetary and fiscal stimulus, as well as extraordinary measures taken to support financial systems.”

It’s important to keep in mind that the primary objective of the BoC is to keep inflation near 2 percent, the midpoint of its 1 percent to 3 percent target range. In fact, the BoC’ describes its inflation-control system as “the cornerstone of the Bank’s monetary policy framework.”

The BoC noted yesterday that core inflation--which excludes volatile food and energy prices--was “higher than in recent months.” The consensus among economists is that inflation hit 1.6 percent in December, after being below zero through much of the summer and part of the fall. The BoC projects that inflation will return to its 2 percent target range by late 2011, though yesterday the BoC specifically said “the third quarter” as opposed to the “second half” of the year.

In addition to the statement announcing the rate decision--the substance of which will be fleshed out in Thursday’s Monetary Policy Report--the central bank also announced yesterday that it will cut back certain extraordinary public market operations it put in place at the height of the global financial panic. This decision is based on reduced demand from the private sector for such assistance and demonstrates that confidence in the system is returning.

The central bank released a new schedule for its term Purchase and Resale Agreements (PRAs) to match maturities more closely to the end-of-June date when its conditional commitment to keep rates unchanged expires. Conceding, as it did the in the interest rate announcement, that the recovery is still on at least questionable (though no longer fragile) footing, in the term PRA announcement the central bank repeated it “remains committed to providing liquidity as required to support the stability of the Canadian financial system and the functioning of financial markets.”

But even though the bank believes that the private sector won’t drive demand until 2011, July will be the time to tap the brakes by boosting borrowing costs. A series of modest hikes, the hope is, will keep Canada on pace to grow about 2.9 percent this year and 3.5 percent in 2011 while easing back up into the inflation-target range.

Yesterday’s statement also included the observation that a strong Canadian dollar, in addition to still-weak demand from the US, continue to be “significant drags” on economic activity. Complicating Mark Carney’s calculus is the fact that the loonie will look even stronger next to the US dollar if the BoC starts hiking rates ahead of Ben Bernanke and the Federal Reserve. This would further hamper Ontario’s already crippled manufacturing complex.

The bank is set to release its next decision on interest rates on March 2.

Surveys Say

Two other, lower profile BoC publications caught our attention during the past week,

the fourth-quarter Business Outlook Survey, which involves interviews with senior management at about 100 companies, and the Senior Loan Officer Survey, which looks at business lending practices.

For the Business Outlook Survey, 70 percent of executives said sales growth will quicken over the next year, while another 21 percent expect it to slow. The gap of 49 percentage points nearly matched the 53 in the last survey, the biggest since the question was first asked in 1998. Executives on balance said for the second quarter since mid-2007 that credit conditions had eased; 26 percent of executives said loans were easier to get, compared with 13 percent who said they were harder. In the last report, the gap was 4 percentage points.

“The results of the winter survey provide some evidence that confidence in the recovery is growing,” noted the BoC. “Respondents still expect the recovery to be gradual.”

As for the Senior Loan Officer Survey, credit conditions eased for the first time since the second quarter of 2007. The so-called balance of opinion on overall conditions was negative 8.7 percentage points; readings less than zero indicate looser conditions.

The percentage of executives who said they would have “some” or “significant” trouble meeting a surprise jump in demand rose to 29 percent from a record-low 22 percent. The balance of opinion on adding to payrolls in the next year was 40 percentage points, the highest since the first quarter of 2007. For investment in machinery and equipment, the balance of opinion was 17 percentage points, the highest the third quarter of 2008.

Most respondents expect inflation to stay within the BoC’s target range; 61 percent--up from 49 percent in the third quarter--expect inflation to remain at the lower end of that range, near 1 to 2 percent. Some 20 percent expect inflation of 2 to 3 percent.

About 26 percent of firms reported “some difficulty” meeting increased demand, up from the third quarter, and 3 percent reported “significant difficulty.” Still, capacity pressures remain historically low, and demand is expected to rise very gradually this year. This is consistent with the view expressed by the BoC in yesterday's interest rate announcement that Canada’s economy is still operating well below capacity.

Disclosure: no positions