Economists Confused by Bank of Canada

Bank of Canada maintains overnight rate target at 1/4 per cent and reiterates conditional commitment to hold current policy rate until the end of the second quarter of 2010

OTTAWA – The Bank of Canada today announced that it is maintaining its target for the overnight rate at 1/4 per cent. The Bank Rate is unchanged at 1/2 per cent and the deposit rate is 1/4 per cent.

Things are looking much better in the world economy after experiencing the significant financial meltdown that began last October. The environment has recovered more than what was expected at this point in time, although fundamentals in the recovery process have a ways to go.

Here at home, Canada’s situation has vastly improved. The growth we’ve witnessed is supported by governments investing billions of tax dollars into the system which has created a rise in personal wealth, improving availability of loan capital for most consumers, higher prices on items such as houses, and stronger business and consumer confidence. As positive as these indicators are, a higher Canadian dollar will also slow growth and halt inflation for the next six months or so.

The loonie’s strength is expected to offset the favorable developments we’ve seen since July. The more international investors take a liking to the Canadian currency, the longer it will take the economy to re-employ the thousands of workers who were laid off throughout the recession.

The Bank of Canada now expects our economy to be driven internally rather than relying so heavily on external factors. Growth is anticipated to be slightly higher in the second half of this year and to average slightly lower over the balance of the projection period. The Canadian economy is forecasted to grow by 3.0 per cent in 2010, and 3.3 per cent in 2011, after contracting by 2.4 per cent this year.

The Bank predicts that inflation will return to 2% levels sometime in a couple of years due to the persistent international weakness. The output gap will be closed in the third quarter of 2011, one quarter later than it had projected in July. Translation: rates aren’t going up anytime soon.

When the BOC reviews all the evidence, it concludes that deflation or at least, declining inflation, will be more a reality than inflation of 2%. Given all the above, the Bank of Canada isn’t changing its previous announced rates. Furthermore, the young economists that predicted the BOC would radically increase rates to cool the red hot housing market were incorrect.

The analysts predicting a decline in house prices and sales due to rising interest rates based on the prime rate are also likely heading in the wrong direction. I use the term “likely” mildly as the BOC has been wrong before and could change their minds if the economy proves to be substantially stronger than anticipated.

In summary, as fundamentals in our economy continue to improve the risk of a rate hike may not really be that far away. However, a strong loonie will continue to stifle growth so it may take longer than expected for the economic landscape to rise again. Confusion reigns supreme, at least, it appears to among economists.