RBC expects BOC rates to rise in July

Canada’s economy is in good shape

Real GDP output contracted slightly in February although this followed two very strong monthly gains and was not enough to derail the economy from posting a solid gain in the first quarter of 2011.
We maintain our forecast for an increase of 3.7% at an annual- ized rate, even stronger than the fourth quarter of 2010's 3.3% rise. We lowered our forecast for growth in the second quarter of 2011 although notably we still expect the economy to expand at an above-potential pace of 2.8% and boosted our third quarter forecast to make up for this near-term slowing. This change reflects our assessment that supply disruptions in the delivery of Japanese autos and parts will dampen manufactur- ing activity in March and April, which will hamper the economy’s ability to grow at a pace that is faster than the first quarter. The return to more normal activity levels, (either by domestic production of parts or increased supply from Japan) sets up for a rebound in the third quarter with the economy likely to grow at a greater than 4% pace.

Inflation rates jump reflecting temporary factors

Canada’s headline inflation jumped to 3.3% in March led by surging gasoline prices and a bump up in food costs. The core inflation rate was also unexpectedly high in March coming in at 1.7%, almost double February’s record low of 0.9%. In the first quarter of the year, core inflation recorded an average gain of 1.3%, and our forecast assumes that this will mark the low for the cycle given the solid upward momentum in the pace of economic growth established late last year. Despite the elevated level of headline infla- tion and steady drift higher in inflation expectations, as measured by real return bonds, concerns about the risk that the strong currency will seep into lower import prices and dampen demand for Canadian exports, kept the Bank of Canada from signalling that it is prepared to restart raising the policy rate in the near term. Our as- sessment is that the risks associated with keeping financial conditions in Canada "exceptionally stimulative" are to the upside for the inflation outlook and outweigh the downside risks associated with currency strength, potential housing market weakness, or a sharp drop in consumer spending activity. We suspect some of the jump in the March inflation rate will be reversed in the months ahead although the higher starting point will likely result in the second quarter's average core inflation rate running hotter than the Bank of Canada’s forecast.

This combination sets up for July rate hike

Confirmation that the economy is bearing up well will be needed to convince the Bank that the risks to the inflation outlook are skewed to the upside making a rate hike at the end of May unlikely. We maintain our call that the Bank will have the ammunition to raise the policy rate in July and expect that the overnight rate will end 2011 at 2.0%, 100bp higher than today. Key to the timing of the resumption of rate hikes is the ability of the economy to deliver solid growth after transitory factors are taken into account. The April Labour Report showed 58,000 new jobs were created and that unemployment rate slid to 7.6%. Further employment growth coupled with firm global demand and persistent business investment are the underpinnings of our view that Canada's economy will grow by 3.2% this year. The Bank of Canada upgraded its growth forecast for 2011 to 2.9% from 2.4% in its April Monetary Policy Report and now expects both the head- line and core inflation rates to hit the 2% target in the middle of 2012. This is a change from the previous forecast that these inflation rates would return to the target by the end of 2012 meaning that the window for the rate to hit the target will close sooner than previously thought. This means that the Bank will have to reduce monetary policy stimulus if policy is going to counter the upside risks to the inflation outlook.