RBC -Bank of Canada raises policy rate on the strong domestic economy but cautious about global events

The Bank of Canada boosted the overnight rate by 25 bps to 0.50% yesterday, hinting that further reductions in amount of stimulus are forthcoming but providing no concrete timetable for additional rate increases. While the domestic economy is performing in line with the Bank’s forecast, the external environment remains volatile, with the Bank pointing to tensions in Europe and the continued deleveraging across the global economy as likely to “temper the pace of global growth.” “Given the considerable uncertainty surrounding the outlook, any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments,” the Bank said.  Additionally, the Bank highlighted that, even with today’s rate increase, there remains “considerable monetary stimulus in place.”

The Bank also announced that it is re-establishing its standard operating framework for implementing monetary policy. The 50 bps operating band for the overnight rate was re-established.

The economy posted a solid 6.1% annualized growth rate in the first quarter of 2010 building on an already impressive 4.9% increase in the fourth quarter of 2009. The solid gains during these two quarters provided strong evidence that the stimulative monetary and fiscal measures helped to pull the Canadian economy out of the recent slump. The 0.6% gain in March’s GDP indicated strong momentum late in the first quarter setting up for the strength to be maintained in the second quarter. The surge in payrolls in April also corroborates this view with a smaller, but still positive, report for May expected on Friday, June 4, 2010.

While the global environment presents risks to Canada’s economic outlook, the strength in the domestic economy and a core inflation rate that is only marginally below the 2% target took precedence in today’s rate decision. Furthermore, the statement indicates that the strength of the domestic economy will see the Bank continue to reduce the amount of stimulus, although the statement did not provide clear guidance about the pace of interest rate increases. So far, the Bank assesses that the effects of external events on Canada’s economy have “been limited.”  On balance, the statement supports our view that the Bank views domestic economic conditions as strong enough that the ultra-low level of interest rates is no longer needed and that the recovery can withstand a gradual rise in interest rates going forward. To that end, we expect that the Bank will raise the policy rate to 1.5% in 2010 and that the tightening will continue in 2011 as the Bank moves the policy rate closer to neutral by the time Canada’s output gap is eliminated.

Source:  RBC:  Dawn Desjardins, Assistant Chief Economist, RBC Economics

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