Dodge treads ‘fine line' amid turmoil
DAVID PARKINSON
Monday, September 03, 2007
This might not have been the most restful Labour Day weekend David Dodge ever had.
While most of Canada's working stiffs were able to put their feet up and enjoy the holiday set aside to honour their labours, the Bank of Canada boss and other central bank officials have a difficult week ahead. The bank is set to issue its latest decision on interest rates Wednesday – a decision complicated by the liquidity problems in the financial markets on the one hand and a stronger-than-expected economy on the other.
“I feel for them,” said Beata Caranci, director of economic forecasting at Toronto-Dominion Bank. “It's a fine line they're walking.”
While economists are almost universal in believing the Bank of Canada will hold its benchmark overnight rate target steady at 4.50 per cent tomorrow, they also largely agree that if not for the uncertainty surrounding the credit markets, the bank would be raising rates to combat inflationary pressures stemming from surprisingly strong economic growth.
Last Friday's gross domestic product report showed the Canadian economy expanded at an annualized pace of 3.4 per cent in the second quarter, more than half a percentage point above the Bank of Canada's estimate of 2.8 per cent contained in its latest Monetary Policy Report Update in July. That means the economy was operating at more than a full percentage point above the central bank's estimate of the economy's production capacity – a significant gap that would normally imply building inflationary pressures and justify interest rate increases.
But the credit turmoil of the past month poses serious risks to the economic outlook; it's believed the financial crisis could infect broader economic activity, though no one can say to what degree. Some pundits had thought the crisis might actually warrant a rate cut by the bank come its October rate announcement, especially if the U.S. Federal Reserve Board proceeds with a widely anticipated rate cut of its own at its Sept. 18 meeting.
Friday's gangbuster GDP data have thrown a new wrench into the machinery.
“[The] report highlights the dilemma the bank faces on the monetary policy front,” Ms. Caranci wrote in a research note. “Financial markets had priced in more than a 60-per-cent chance that the bank would cut rates by a quarter point by year-end. This looks overly optimistic from an economic standpoint.”
In light of the GDP report, bond traders on Friday largely unwound their bet that a Canadian rate cut was in the cards for October. Government of Canada two-year bond yields jumped 14 basis points to 4.345 per cent.
Meanwhile, the tone of financial markets perked up on Friday, thanks to some calming statements from both President George W. Bush and Fed chairman Ben Bernanke. Mr. Bush unveiled a plan to help protect homeowners at risk of defaulting on their mortgages, while Mr. Bernanke's speech implied that the Fed is still likely to lower interest rates later this month to ease credit-market-related pressures.
While economists believe Canada's economy is in a much stronger condition than the U.S. economy, they agree potential spillover from the credit turmoil remains a big economic wild card. The problem is, it's too early to tell what effect this turmoil in markets may be having on the North American economy.
As a result, most economists believe the Bank of Canada must take a wait-and-see approach, despite the strong economic pace.
“In this environment, it still appears that the next move by the Bank of Canada will be to eventually start hiking rates again, although the depth and duration of the credit squeeze will determine when they get back to the tightening wheel,” said Douglas Porter, deputy chief economist at BMO Nesbitt Burns.
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