By David Veitch
Canadian capacity pressures and inflation expectations soften
At 10:30AM 17/10/2011, the Bank of Canada released the results of the Autumn Business Outlook Survey, which showed business sentiment has softened relative to the summer. The survey was taken between August 22 and September 22, and given the events which have transpired in Europe, the United States, and China since the summer survey (taken between May 24 and June 16), it is unsurprising that business outlooks in Canada have become less rosy.
Implications for the Bank of Canada
This survey, the simultaneously released Senior Loan Officer Survey, and the CPI reading that will be released on October 21 are inputs the Bank of Canada will consider in their upcoming October 25 interest rate decision. While on a relative basis both the Business Outlook Survey and Senior Loan Officer Survey are less important than the CPI number to be released on Friday, they are still worth examining to determine how the Bank of Canada will act going forward.
How to Read the Survey
Two closely watched figures in the Bank of Canada’s Business Outlook Surveys are capacity pressures (a proxy for the measurement of Canada’s output gap) and inflation expectations. These figures are closely examined by the markets as they give insight into what the Bank of Canada is thinking in terms of future interest rate decisions. This is in line with the Taylor Rule school of thought, which asserts that nominal interest rates (i.e. the Bank of Canada’s overnight rate) should be set as a function of the equilibrium real interest rate, the output gap, and current inflation versus the desired rate*. Capacity pressures can be considered the more important figure in this survey, given that readings on the Canadian output gap are few are far between; this compares with expected inflation readings, which can be taken daily by looking at the breakeven yields on real-return bonds.
Capacity pressures, as measured in this survey by firms’ abilities to meet unexpected increases in demand, have in the past been successful in forecasting the Canadian industrial capacity utilization rate and the estimated output gap. This is demonstrated in this figure’s t+1 (in quarters) correlations with industrial capacity utilization and the estimates of the output gap of 0.88 and 0.77, respectively.
In comparison, the inflation expectations embedded in the Business Outlook Survey have less predictive power with the variables they are forecasting, that is Total CPI and Core CPI.
On both counts in the survey, capacity pressures and inflation expectations, it appears that the case for the Bank of Canada to hike rates which existed in the summer has somewhat diminished since the output gap is now wider and inflation expectations are more firmly anchored. Whereas in the summer 51% of firms responded that they would have at least some difficulty in meeting an unexpected increase in demand, the proportion in the autumn survey stands at 43%. Firms’ inflation expectations have diminished since “inflation expectations [are now] more heavily concentrated in the Bank’s inflation-control range of 1 to 3 per cent, and have become more evenly split across the upper and lower half of that range.”
Another important point to note is the continued easing of credit conditions that has occurred over the past three months. This easing of credit conditions somewhat weakens the case for further easing by the Bank of Canada, since credit is very available as it is.
While it would be dangerous to read too far into any of the numbers included in the report, one thing to watch in the winter version of the Business Outlook Survey will be firm expectations of changes in input and output prices. The autumn readings in these two categories represent their lowest levels since 2008, and it will be interesting to see whether or not this is just a temporary blip.
Read-Through to the Bank of Canada
While there was nothing earth-shattering to take away from the most recent Business Outlook Survey, it does demonstrate that Canada is clearly not an island in the context of the global economy. This fact has meant that the events which have transpired in the global economy over the past several months have weighed on Canadian businesses’ outlooks. While this set of data points are unlikely to sway the Bank of Canada either way at its October 25 interest rate decision, it will definitely have to be considered by market participants in the context of upcoming data releases as to what and when the Bank of Canada’s next moves will be.
Note that all graphs, unless otherwise noted, are directly from the Autumn 2011 Bank of Canada Business Outlook Survey
*While the Bank of Canada or even the Federal Reserve in the United States do not explicitly follow the Taylor Rule, many have noted that their interest rate decisions have at times closely mirrored those that the Taylor Rule would produce.