Bank of Canada Governor David Dodge is betting the worst is over for the U.S. economy, and that the Canadian economy is now quickly picking up speed. But it's a bet that is high risk, economists say — even those who generally agree with his assessment.
The central bank announced yesterday its key interest rate would remain unchanged at 4.25 per cent, and gave no indication about any move up or down any time soon. The justification for its pause — which began last May — hinges on a quick recovery in the United States.
“There are signs that a significant amount of the adjustment in the U.S. housing and automotive sectors has already taken place and that the inventory correction in Canada is well advanced,” the central bank said in a press release. “Accordingly, the bank projects that economic growth in Canada will pick up to about 2½ per cent in the first half of 2007.”
Holding interest rates steady was the right thing for the central bank to do, given the uncertainty of how well the Canadian and American economies will do in the months ahead, economists generally agreed. But it's too soon to confidently declare an end to the U.S. slump and pin Canadian monetary policy to such a delicate recovery, they added.
It would have been nice to see some hint by the Bank of Canada that it would be willing to ease monetary conditions if things take a turn for the worse, said David Wolf, economist with Merrill Lynch Canada Inc.
“The upshot is the bank may well be correct in that the economy is going to recover nicely in 2007,” Mr. Wolf said. But Mr. Dodge has been wrong about economic growth for most of 2006, because he overestimated the strength in the U.S. economy, and he probably will be wrong again, he said.
“The adjustment in U.S. housing and autos is almost certainly not entirely over, but the real question is whether it's substantially over. And I think probably not.”
As well, Canadian inventories are still high, and probably have some more correcting to do, he added.
While the central bank is upbeat about the coming quarters, it slashed its expectations in half for the fourth quarter of last year. U.S. demand for building materials and motor vehicles slumped, hurting Canada's exports and compelling Canadian companies to run up inventories, the bank said. As a result, Canadian growth probably increased at a 1.6-per-cent annual pace for the last half of 2006, the statement explained.
Those numbers imply an annualized growth rate of about 1.5 per cent for the fourth quarter — a steep reduction from the central bank's original projection of 2.8 per cent. More precise numbers will likely be published Thursday in the bank's quarterly economic update.
Despite the major revision to the fourth quarter, the central bank is sticking to its original forecast for 2007, expecting a 2.5-per-cent rate of expansion in the first half of this year. That implies a quick acceleration in the Canadian economy, analysts said.
While economists say there are some good reasons emerging to believe that a recovery is under way, such as a tight labour market and strong consumer demand in Canada, the central bank is clearly hitching its case to the U.S. economy.
Mr. Dodge is engaged in some wishful thinking, said Patricia Croft, chief economist at Phillips Hager & North Investment Management.
“I think that the housing cycle may have another leg down,” she said. “I think that it will have to play out over years and not just months. I'm still kind of waiting for that second shoe to drop.”
At BMO Nesbitt Burns, deputy chief economist Douglas Porter believes there are signs that the U.S. housing slump has bottomed out, but he's not ready to bet the farm on it like Mr. Dodge.
“There's lots of downside risk for the U.S. economy,” he said.
The central bank did not say a word about the Canadian dollar, which has slid steadily from above 90 cents (U.S.) in September, 2006, to below 85 cents this month. While analysts said the omission probably means the Bank of Canada believes the depreciation is justified by lower commodity prices, they hope to hear more from the central bank in Thursday's report and news conference.
The central bank also tweaked its inflation forecast yesterday, saying that the core inflation rate (which excludes energy, food and some other volatile items) will drift quickly back to about 2 per cent in the first half of this year, and stay there. Core inflation rose by 2.2 per cent in November, compared with a year earlier.
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