Canada’s economy kicked it up a notch in Q1/11

Canada’s economy kicked it up a notch in Q1/11

First-quarter 2011 real GDP grew at a 3.9% annualized pace, the fastest since the first quarter of 2010. The details of the report showed significant reliance on inventory building, minimal support from consumer spending, and external trade acting as a drag on the pace of activity in the quarter.


Business investment was another key source of strength for the economy (along with inventories) in the first quarter, with both residential and non-residential construction supplementing a strong quarter of investment in capital goods. This composition, in our assessment, sets up for a somewhat slower pace of growth in the second quarter. Further downward pressure on GDP will likely come from the manufacturing sector reflecting disruptions to auto production caused by falling supply of Japanese autos and parts due to the earthquake and tsunami affecting that economy. We forecast that the second-quarter 2011 growth rate will moderate to a 2.8% annualized gain although activity should rebound during the second half of the year as much of these transitory factors ease.

Bank of Canada sounds warning bell

The Bank of Canada left the policy rate at 1.0% at its meeting earlier this week. The press release highlighted that the global economy was recovering in line with expectations and that the challenges to the outlook (from a myriad of different factors) were being offset by very stimulative financial conditions. Canada’s economy was also characterized as performing in line with the Bank’s projections, and although supply disruptions will “restrain growth sharply” in the second quarter, the Bank forecasts that this slowing will prove to be temporary.

Importantly, the Bank highlighted that if the domestic “expansion continues and the current material excess supply in the economy is gradually absorbed, some of the considerable monetary policy stimulus currently in place will be eventually withdrawn.” This is a more aggressive statement than in the previous rate decision press releases and the April Monetary Policy Report. Additionally, the Bank highlighted that “greater momentum in household spending” may present an upside risk to inflation. In recent statements, the Bank has tended to focus on the downside risks stemming from the strength of the Canadian dollar and commensurate decline in import prices as potentially dampening inflation pressures. The mention of the upside risk in this press statement underscores the Bank’s assessment that the need for the currently exceptionally low level of interest rates is dwindling.

Inflation — is it hot or not?

Canada’s inflation rates have been running slightly hotter than the Bank’s forecast. The core rate started the second quarter of 2011 at 1.6% and the headline rate at 3.3%. The headline rate, however, is being boosted by temporary factors including the changes in some of the provincial tax rates and rising commodity prices. The Bank expects this to result in the headline rate holding above 3% in the near term with RBC forecasting an average 3.2% increase in the second quarter. These temporary factors are forecasted to fall out of the annual growth rate in July, in the case of the provincial sales tax changes, and exert more modest pressure on the index, in the case of energy prices. In the medium term, which is the focal point for the Bank’s setting of interest rates, we agree with the Bank’s projection that both the headline and core rates will converge at 2% in the middle of next year.

Is a rate hike coming?

In the near term, the Bank is likely to maintain a policy rate of 1.0% in order to ensure that the expected slippage in the pace of domestic economic growth (due to temporary factors) does not become ingrained especially given the heightened global uncertainties. As the Japanese economy enters a period of reconstruction and Canadian manufacturers find alternative sources for inputs that are in demand, the effect of the supply-chain disruptions will lessen, meaning that the weakness in the spring quarter will likely be followed by stronger growth in the second half of the year. Additionally, we expect there will be more clarity about the economic effect of some of the key international issues that are currently plaguing parts of the global economy. As Canada’s domestic economy reaccelerates and the external environment calms, we expect the Bank to resume weaning the economy from the extraordinary stimulus with a rate hike in September likely to kick off a series of increases. We are forecasting 25 bp rate increases at all three meetings in the latter part of 2011, meaning that the policy rate will end the year at 1.75%. With the domestic economy maintaining an above-potential growth rate in 2012 and the pace of expansion in the US building, rate increases will carry on in 2012 and we forecast a 3.0% overnight rate at the end of next year.