Market Watch: Bank of Canada

Will interest rates be cut on December 4?

The Bank of Canada meets on December 3rd and 4th next week to deliberate and to deliver the Central Bank’s latest monetary policy decision (Tuesday the 4th). This is arguably the most important policy decision in 18 months as much has changed since the Bank last met in early October. Inflation has slowed, with the Bank’s preferred core rate falling to 1.8% in October, the slowest rate of inflation since June 2006. The headline rate also slowed, to 2.4% from 2.5% in September. Inflation is now lower in Canada than in the US and with the Fed in an easing cycle, the Bank of Canada is expected to follow suit, albeit in a less aggressive manner than the Fed. The key question is whether the Bank of Canada will move to cut rates now or wait until early 2008. Recent economic data may well make the decision somewhat less painful for the Bank and it will be something of a surprise to me if rates are not cut next week.

Underlying fundamental data points to some deterioration in the Canadian economy: retail sales in quarter 3 recorded the first quarterly decline since the final quarter in 2003; exports have dropped significantly over recent months, particularly for durable goods and in September the economy’s trade balance narrowed to its lowest level in 4 years; manufacturing shipments are falling consistently with outlook bleak as new orders are falling at a sharpened rate; GDP for quarter 3, reported later this week, is expected to print at an annualised 2.3% rate, down substantially from the 3.4% rate recorded in quarter 2 and the 3.9% reported for quarter 1. On top of this we have a scenario where the neighbouring US economy is slowing and is expected to slow further, hardly good news for the export-oriented Canadian economy, where 80% of all exports go to the US. To round it off we have the Canadian dollar still trading 20% higher on the year against its US counterpart, which is taking a huge slice off corporate profits and rendering many Canadian manufacturers and exporters uncompetitive or redundant. The global economy too is showing distinct signs of weakness and the idea that a commodity-rich Canada can flourish while the country’s major trading partners sink is far-fetched.

The time is nigh for the Bank of Canada and it is pointless them using the record tight labour market in Canada to adopt a wait and see approach. Labour is a lagging indicator, but jobs will be shed very quickly when things turn nasty, and the undercurrents already suggest the screw is turning. By acting now the Bank of Canada will demonstrate they are thinking proactively, while a cut should also mean some further correction in the value of the loonie and at least allow Canadian producers compete at a fairer exchange level on international markets. Governor David Dodge has complained that Canada has had to carry too much of the burden of a weakened US dollar, but the way to right this wrong is to help drive the Canadian currency to a more realistic value level. While currency valuation is not the policy imperative of the Bank of Canada, currency manipulation on the part of the speculators that have placed Canada’s economy at risk should be.

In any event, aside from the risks posed by a strong Canadian dollar, recent domestic data in Canada points to an economy which is slowing, an inflation rate which is slowing and increasing external risk from growing uncertainty in the US and global economies. Why wait? Forecast: Bank of Canada to cut the key interest rate from 4.5% to 4.25% on December 4.

Ted B - Nov 26