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Where are interest rates in Canada heading?
Economics & Strategy www.cibcwm.com/research
May 18, 2006
Economic Update
Both the Fed and the Bank of Canada made it clear that any decision regarding future monetary policy action will be heavily dependent on economic numbers. So, let’s take a look and see what the data is telling us as of today.
In the US, there are three main factors to focus on: developments in core inflation, commodity prices, and the housing market.
• US core inflation rose by 2.3% (year-over-year) in April. That was a bit stronger than the market expected and revived speculations regarding a Fed’s tightening move come June 28th. Note that most of the increase in core inflation was in services, in general, and rent, in particular. The recent acceleration in rent inflation is consistent with an ongoing fall in vacancy rates. Regardless of the sources, inflation is inflation, and the Fed is probably a bit nervous.
• Commodity prices are softening, with the prices of metals falling notably in recent days. Note that the Fed has been pointing to commodity prices as an inflationary risk, so any softening here is a welcome development from the Fed’s perspective.
• The US housing market is slowing very fast. Almost every number is on the decline. Housing starts are now 18% below their peak whereas the median house price is 5% below its peak, and homebuilders’ sentiments are at their lowest level in more than 15 years. Clearly, the housing market is softening, and we all know how significant the housing market has been in stimulating the economy, in general, and consumer spending, in particular. In fact, in its communication to the market after raising rates, the Fed started its statement with the housing market ― clearly indicating that this factor is being monitored very closely.
So, we have some acceleration in US inflation, but commodity prices are softening and the housing market is slowing. What to do? An important factor to remember here is that the Fed has already tighten monetary policy by no less than 400 basis points and that long-term rates have risen in recent months. So, there are many basis points in the pipelines that are yet to fully impact the economy. Our assessment is that the Fed might move one more time in June or early August, but that would be the end of the tightening cycle.
As for Canada, the main issue is inflation. And the numbers look good. Yes, the headline inflation numbers rose by 0.5% in April (mainly energy) but core inflation (ex energy and food), in fact, fell by 0.1%. On a year-over-year basis, core inflation fell from 1.8% to 1.6% ― 4 points below the Bank of Canada’s target. Why inflation in Canada is still so low while inflation in the US is on the rise? The main reason is the Canadian dollar. The high import
CIBC WORLD MARKETS INC. 2
content of the Canadian consumer baskets more than offset the tight levels of employment and capacity use in Canada. The price of clothing fell by 2% last year, and if you are in the market for a new DVD or TV, they are cheaper by 4% than a year ago.
What are the implications? The dollar is clearly becoming the most important factor impacting the Bank’s rate decision. Note that inflation now is below the Bank of Canada’s forecast. In fact, the market is now attaching only a 25% probability that the Bank will raise rates come May 24th. But the issue is not whether or not the Bank moves on the 24th; the more important issue is that this kind of debate is a clear indication that we are getting very close to the end of the tightening cycle.
As for long-term rates, while low inflation in Canada is working to limit inflationary expectations and thus any upward pressure on bonds yield, we have to remember that Canadians bonds are often influenced by developments in the US bond market. And since we expect some upward pressure there, we might see additional moderate increases in long-term Canadian rates, say another 15-20 basis points in the coming few months. Beyond that, the best guess is that rates will stabilize for a while before starting a moderate downward trend, possibly in mid to late-2007.
Benjamin Tal
Senior Economist, CIBC World Markets
Economics & Strategy www.cibcwm.com/research
May 18, 2006
Economic Update
Both the Fed and the Bank of Canada made it clear that any decision regarding future monetary policy action will be heavily dependent on economic numbers. So, let’s take a look and see what the data is telling us as of today.
In the US, there are three main factors to focus on: developments in core inflation, commodity prices, and the housing market.
• US core inflation rose by 2.3% (year-over-year) in April. That was a bit stronger than the market expected and revived speculations regarding a Fed’s tightening move come June 28th. Note that most of the increase in core inflation was in services, in general, and rent, in particular. The recent acceleration in rent inflation is consistent with an ongoing fall in vacancy rates. Regardless of the sources, inflation is inflation, and the Fed is probably a bit nervous.
• Commodity prices are softening, with the prices of metals falling notably in recent days. Note that the Fed has been pointing to commodity prices as an inflationary risk, so any softening here is a welcome development from the Fed’s perspective.
• The US housing market is slowing very fast. Almost every number is on the decline. Housing starts are now 18% below their peak whereas the median house price is 5% below its peak, and homebuilders’ sentiments are at their lowest level in more than 15 years. Clearly, the housing market is softening, and we all know how significant the housing market has been in stimulating the economy, in general, and consumer spending, in particular. In fact, in its communication to the market after raising rates, the Fed started its statement with the housing market ― clearly indicating that this factor is being monitored very closely.
So, we have some acceleration in US inflation, but commodity prices are softening and the housing market is slowing. What to do? An important factor to remember here is that the Fed has already tighten monetary policy by no less than 400 basis points and that long-term rates have risen in recent months. So, there are many basis points in the pipelines that are yet to fully impact the economy. Our assessment is that the Fed might move one more time in June or early August, but that would be the end of the tightening cycle.
As for Canada, the main issue is inflation. And the numbers look good. Yes, the headline inflation numbers rose by 0.5% in April (mainly energy) but core inflation (ex energy and food), in fact, fell by 0.1%. On a year-over-year basis, core inflation fell from 1.8% to 1.6% ― 4 points below the Bank of Canada’s target. Why inflation in Canada is still so low while inflation in the US is on the rise? The main reason is the Canadian dollar. The high import
CIBC WORLD MARKETS INC. 2
content of the Canadian consumer baskets more than offset the tight levels of employment and capacity use in Canada. The price of clothing fell by 2% last year, and if you are in the market for a new DVD or TV, they are cheaper by 4% than a year ago.
What are the implications? The dollar is clearly becoming the most important factor impacting the Bank’s rate decision. Note that inflation now is below the Bank of Canada’s forecast. In fact, the market is now attaching only a 25% probability that the Bank will raise rates come May 24th. But the issue is not whether or not the Bank moves on the 24th; the more important issue is that this kind of debate is a clear indication that we are getting very close to the end of the tightening cycle.
As for long-term rates, while low inflation in Canada is working to limit inflationary expectations and thus any upward pressure on bonds yield, we have to remember that Canadians bonds are often influenced by developments in the US bond market. And since we expect some upward pressure there, we might see additional moderate increases in long-term Canadian rates, say another 15-20 basis points in the coming few months. Beyond that, the best guess is that rates will stabilize for a while before starting a moderate downward trend, possibly in mid to late-2007.
Benjamin Tal
Senior Economist, CIBC World Markets
