Canada well braced for headwinds: BoC
Heather Scoffield, The Globe and Mail - July 17, 2008

Canada's economy will soldier on, with core inflation well under control and growth picking up gradually — despite the U.S. downturn, ongoing financial market turmoil and the slowing global economy, the Bank of Canada said in its quarterly economic outlook.

Total inflation is expected to spike up to 4.1 percent in the final quarter of this year because of soaring energy prices, the central bank reiterated, but that inflation won't be contagious, and core inflation is well in hand.

"Core inflation is projected to remain well contained and broadly in line with earlier expectations," the bank said in its surprisingly sanguine Monetary Policy Report Update, which suggested interest rates will remain on hold for the time being.

Even with total inflation persisting far above three percent for the entire next 12 months, core inflation — which excludes the most volatile prices such as energy and some food, but includes 82.7 per cent of purchases — will barely budge, inching higher to reach 2.0 percent only in the second half of 2009, the bank said.

The projection flies in the face of the bank's own survey, which shows that a sizable portion of Canadian companies plan to pass along higher input costs to their customers.

The central bank suggests this pass-through effect won't happen, partly because the Canadian public's inflation expectations are well anchored, and partly because supply is outpacing demand right now.

Core inflation will also stay muted because housing prices are no longer soaring, the bank said.

"Deceleration in the growth of housing prices largely offsets the expected acceleration of food prices," the report explained.

Total inflation will eventually taper off to meet the pace of core inflation in the second half of 2009.

Canada's economic growt has nowhere to go but up, the bank added. The drawdown on inventories that took a big bite out of economic growth in the first quarter is now over, and the Canadian economy can resume its growth track.

After an unexpected contraction in the first quarter of the year, annualized growth in the second quarter likely rebounded to 0.8 percent, and will steadily pick up speed over the next two years, the bank forecasted.
It expects a 1.3-percent pace in the third quarter, a 1.8-percent pace in the fourth quarter, followed by 2.8 percent in the first half of 2009, and 3.2 percent in the second half of 2009.

Even though global growth will slow in the second half of 2008, Canada will gain momentum because the domestic economy is benefiting from a massive injection of money coming from high commodities, the bank suggested.
Canadian exports will remain in bad shape, declining 1.1 percent this year in real terms, and will see no growth next year. But as the U.S. economy recovers, so will Canada's trade prospects.

The U.S. economy is expected to grow a modest 1.6 percent this year, but that's much better than earlier Bank of Canada projections of 1.0 percent for Canada's biggest trading partner.

Still, for Canada, the central bank sees a total of just one percent growth this year — lower than its previous forecast of 1.4 percent. The main culprits are a slow start to the year, and decelerating domestic demand. While it is expected to remain healthy, it is softer than previously expected — hampered by a moderation in the housing market and slower growth in household credit.
The bank's assessment of the Canadian and global economy made only oblique references to the turmoil that has gripped financial markets and American financial institutions this week, and thrown U.S. policy makers into a panic.

"Conditions in global financial markets continue to be unsettled," the report stated. "The ongoing re-intermediation of assets onto bank balance sheets and the de-leveraging of the financial system are expected to weigh on global credit markets for some time."

But Canada is still managing to side-step most of that carnage, the bank pointed out.

"Although credit conditions in Canada remain challenging, they are better in many respects than those in other major markets."
Corporate and household borrowers have seen their effective borrowing costs drop by about 75 basis points over the past year, the bank estimates. That's because the central bank has cut its own key interest rate by 150 basis points, and while half of those cuts were wiped out by increased global borrowing costs faced by Canadian financial institutions, the other half managed to trickle through.

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Canada's strong economy and dearth of high-risk mortgage lending should help the real estate sector withstand the volatility that's been buffeting the equity markets.

Investors worried about the fallout from defaults on high-risk mortgages in the United States have sent stock markets, including the Toronto Stock Exchange, on a bumpy ride. But barring the unlikely event of the market correction snowballing into a full-blown macroeconomic crisis, the Canadian real estate market should be relatively unscathed by the turbulence, said Benjamin Tal, senior economist at CIBC World Markets.

"I think that the fundamentals of the economy are relatively strong and this crisis is really about fear rather than reality. Also, traditionally we have seen a situation where the housing market does relatively much better than the stock market in periods of correction because it's like comfort food," Mr. Tal said.

In the U.S., loans given to high-risk borrowers at low interest rates, known as subprime mortgages, created "artificial demand" that sent house prices soaring, Mr. Tal said. This was exacerbated by speculators buying investment properties and trying to flip them at a profit. When interest rates went up, defaults soared, spilling over to hurt both lenders and investors who buy and sell mortgage-related debt.

Canada has not experienced the same woes because "we did not push the envelope in terms of exotic mortgages," Mr. Tal said.

A rise in house prices here has been sparked by real demand rather than speculation and compensates for the stagnancy of the market between 1992 and 1997, he added.

The Canadian unemployment rate is at its lowest point in more than 30 years, and that's boosted personal income levels and fuelled demand for residential real estate. Last month, the price of a resale home in Canada hit $332,442, a 13.1-per-cent increase from the previous July, according to statistics released this week by the Canadian Real Estate Association. Sales are expected to reach 514,450 units for the year, the highest level on record and a 6.5-per-cent increase from last year.

The housing market is expected to grow at a more moderate pace next year. However, this will be the result of decreasing affordability rather than the impact of U.S. subprime woes, said Craig Alexander, deputy chief economist at Toronto-Dominion Bank.

"There's no direct tie between the U.S. housing market and the Canadian market. The risk I'm more concerned about is if the volatility continues, there's a greater chance financial institutions in the U.S. could decide to cut back on the amount of credit they're willing to lend to consumers. That would impact Canadian trade, pull down Canadian economic growth, and could eventually trickle down to weaken our housing market."

In terms of borrowing costs, the U.S. mortgage crisis could actually have a silver lining for Canadian home buyers, Mr. Alexander said.

That's because the resultant credit market woes have made the Bank of Canada less likely to raise its overnight interest rate when it meets next month, he said. The overnight rate is used by banks to set the prime lending rate for their best customers, and that in turn is what variable mortgage rates are priced on.

Fixed-rate mortgage rates could also edge down if nervous investors continue to move their money from stocks into lower-risk investments such as government bonds. That's because fixed-rate mortgages move in tandem with bond yields, and bond yields drop when increased demand sends their prices higher.