Bank of Canada sends mixed message on economy

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The Canadian economy will finally pick up steam in the second half of this year, the Bank of Canada says, attributing its optimism to a climb in exports that are expected to shoot past levels not seen since before the 2008 recession.

Bank of Canada Governor Stephen Poloz's upbeat tone on Wednesday surprised some economists, given that the bank lowered its forecast for economic growth for the full year as it released its quarterly Monetary Policy Report.

His message was decidedly mixed: Exports are recovering but are still disappointing; the U.S. economy is showing signs of strength, but business investment is weaker, both at home and in the United States.

Mr. Poloz also issued another warning about the hottest housing markets in the country, saying financial vulnerabilities, particularly in Vancouver and Toronto, are "elevated and rising."

The sharp rise in housing prices in these two markets are not justified by economic fundamentals, he said.

"For us, therefore, that there could be a period of either flat or declining prices in a market like Vancouver, that risk is rising but not really quantifiable," he said. "It's clearly rising."

The bank's optimism about the second half of the year stems partly from signs of strength in the U.S. economy, which would help growth in Canada. But Mr. Poloz cautioned that there is considerable uncertainty in the global outlook because of factors such as Britain voting to exit the European Union, and the U.S. election.

He also addressed the major shift taking place in the Canadian economy as it relies less on commodities and more on non-energy exports.

"The export recovery is alive and well," Mr. Poloz told a news conference in Ottawa, describing the "impressive" climb in exports since the 2008 recession. "You kind of have this narrative that nothing's happened, and yet what you see is actually seven or eight years of recovery. A slow recovery for sure, but one that's been steady."

At the same time, however, the bank lowered its forecast for economic growth this year partly because export figures did not meet expectations.

The central bank announced, as expected, that it will keep its overnight interest rate at 0.5 per cent. That decision came the day before the Bank of England announces whether it will cut interest rates below 0.5 per cent, with economists divided on whether that move will come now or later, probably in August.

The Bank of Canada has repeatedly issued statements about the housing market, but Wednesday's warning marks the first time it cited elevated risks in Vancouver and Toronto in its interest-rate statement.

CIBC economist Nick Exarhos said the stronger language regarding housing risks in those two markets signals that the Bank of Canada will not raise interest rates any time soon.

"I think it's a relatively firm signal that the bank is going to be on the sidelines for the foreseeable future," Mr. Exarhos said. "I don't think they would insert such explicit language in there had they not been wanting to highlight that this is an area of concern for them."

Bank of Canada senior deputy Governor Carolyn Wilkins reiterated the bank's position outlined in last month's Financial System Review that the housing price growth rates are outpacing fundamentals and are unsustainable.

Derek Holt, vice-president of Scotiabank Economics, said the Bank of Canada's warning on vulnerabilities in Vancouver and Toronto indicates that there will be a prolonged pause of the interest rate.

"The impact of the Bank of Canada's rate cut, and also global bond market developments, has been to add further heat to Canadian housing markets," Mr. Holt said. "Now if you were to speak about rate increases, you could wind up popping that bubble."

The July report forecasts real gross domestic product growth of 1.3 per cent in 2016, which is down from the 1.7 per cent projected in April. Growth for 2017 is now projected to average 2.2 per cent, a decline from the 2.3-per-cent forecast in April.

It marked yet another lowering of growth forecasts for a Bank of Canada Governor who has expressed frustration in recent years with the "serial disappointment" of the Canadian economy. Yet bank officials stated Wednesday that they believe the weak start to 2016 was largely temporary, and they stood by the view that exports unrelated to commodities are picking up the slack created by low oil prices and a struggling energy sector. Federal fiscal policy, including new benefit payments to families and billions in infrastructure spending, is also expected to boost growth.

Some economists cast doubt Wednesday on the likelihood that an export-led recovery is right around the corner.

Laurentian Bank chief economist Sébastien Lavoie said in a research note that the bank's own business survey results showed managers reported dismal sales prospects for the coming year. "In other words, it is even less obvious than before to claim that the worst is in the rear-view mirror," he said.

Mr. Poloz had previously said the Canadian economy would return to its potential at some point in the second half of 2017, but the bank now expects the closing of what it calls the output gap will occur "somewhat later" and toward the end of 2017.

The July report marks the bank's first comprehensive assessment of how the economic shocks of last month's Brexit referendum vote in favour of Britain leaving the European Union, as well as the Alberta wildfires in May, will affect growth.

The fallout from the Brexit vote on Canada is expected to be modest, with the bank estimating a 0.1-per-cent reduction in the level of Canadian GDP. Canada's direct trading relationship with Britain is relatively small, accounting for just 3.5 per cent of Canadian exports.

As for the wildfires in Fort McMurray that led to mass evacuations and temporary production shutdowns in the oil patch in May and June, the bank estimates real GDP growth was reduced by about 1.1 percentage points in the second quarter as a result. However, the return of oil production and rebuilding activity in the region is expected to more than offset that decline in the third quarter.

While oil prices have increased nearly $10 (U.S.) a barrel since April, the bank said prices are still below what is required for many oil producers to break even and are not high enough to encourage new investments in oil sands projects.

Toronto-Dominion Bank economist Brian DePratto said in a research note that the central bank is essentially concluding that the bumps Canada has faced this year are not enough to knock the economy off course.

"That said, these bumps reinforce the expectation that the Bank of Canada's foot will remain firmly on the accelerator, with the benchmark overnight rate likely to be held at 0.5 per cent for some time to come," he said.