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Observers are waiting to see if Bank of Canada Governor Stephen Poloz will decide to follow up January’s surprise rate cut with another quarter-percentage-point reduction.

BLAIR GABLE/REUTERS

In a year when the Bank of Canada has already stunned markets with an out-of-left-field interest-rate cut, it's hard to imagine another rate-setting decision by the central bank could match that sort of drama. But this Wednesday's scheduled rate announcement from the bank could come a close second.

After a string a disappointing economic indicators that strongly suggested the Canadian economy had contracted for a second straight quarter, financial markets and central-bank watchers are abuzz with will-he-or-won't-he anticipation: Will Stephen Poloz, the central bank's governor, decide to follow up January's surprise rate cut with another quarter-percentage-point reduction, to throw a life preserver to an economy that may (or may not, depending on whom you ask) have already sunk into a small recession?

Until a few days ago, financial markets saw a cut in the central bank's key rate, to 0.5 per cent from the current 0.75 per cent, as a 50/50 coin toss; most of the economists at the country's six big banks believed a cut was likely. But after last Friday's employment statistics for June, which showed a small decline in jobs in the month but suggested that the labour market continues to hold up quite well, traders aren't so sure. Overnight index swaps, the key bond-market indicator of central-bank interest-rate expectations, were signalling by Friday afternoon that the market had trimmed its call to a 33-per-cent chance of a rate cut this week.

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Much of the debate now centres on just how bad the central bank feels the Canadian economy really is.

It's entirely likely that the country followed up its small decline in gross domestic product in the first quarter with a similar drop in the second quarter ended June 30. As such, the traditional two-straight-quarterly-contractions rule of thumb for a recession was met.

But some economists point out that the relatively healthy labour market is at odds with a true recession. The economy added nearly 100,000 jobs in the first half of the year, and more than 135,000 full-time jobs – not the typical sign of a shrinking economy.

"We'll call this the Great Canadian Non-Recession," said Bank of Nova Scotia economist Derek Holt in a research report last week. "GDP growth is perhaps being temporarily disrupted by the worst and typically concentrated effects of the drop in oil prices, a harsher-than-usual winter and spillover effects on North American supply chains of the strikes that crippled West Coast ports in the U.S."

"The country is not in recession in any meaningful or broadly defined way at this point," he said.

Nevertheless, another rate cut has become more a question of when, not if. The market is pricing in a nearly three-in-four chance of a cut by the bank's September rate setting, and a 100-per-cent likelihood that it will be a done deal by the December meeting.

The Bank of Canada will update its economic forecasts in its quarterly Monetary Policy Report that it will issue in conjunction with Wednesday's rate decision, and it looks certain to reduce its GDP growth estimates for both the second quarter and the year as a whole. The second quarter won't come anywhere near the 1.8-per-cent annualized growth rate that the central bank projected in its previous outlook in April; it would be lucky to even be above zero. That means the bank's full-year growth projection of 1.9 per cent will almost certainly be revised downward.

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The less-than-expected growth implies that the expected timing for the closing of the economy's output gap (i.e. the difference between the economy's productive capacity and how much it is actually producing) may have to be pushed back from the bank's current estimate of late 2016. Even if Mr. Poloz and his colleagues decide not to cut their interest rate this week, any mention of a further delay in returning the economy to full capacity should be taken as a flashing green light for a September rate cut.

There is one key piece of information that the Bank of Canada won't have at its disposal in its deliberations leading up to Wednesday's announcement: inflation. The central bank's rate policy is guided by an inflation target of 2 per cent, and all its analysis of various economic forces is ultimately tied to their expected impact on the country's inflation rate. Unfortunately, the June Consumer Price Index report doesn't come out until Friday – two days after the rate decision.

Economists expect that total CPI inflation will come in at 1 per cent year-over-year in June, up from 0.9 per cent in May. The Bank of Canada's core inflation rate – which excludes the eight most volatile components of CPI, and is considered a more accurate gauge of underlying inflation trends – is expected to be 2.1 per cent, down slightly from 2.2 per cent in May. The core rate has been running above the central bank's 2-per-cent inflation target for the past 10 straight months, but the bank believes the rate has been boosted by temporary factors, most notably the depreciation of the Canadian dollar. It believes true underlying inflation is closer to 1.6 to 1.8 per cent.

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