In early May (the 18th) I discussed Q1 GDP performance that was then estimated to be around 3.2%, but many economists anticipated that this was a misread, and that the actual number would be much higher – around 5.5%. The actual headline number at 6.1% is 0.6% higher than most economists had expected then (and about 30 bps higher than the street expected last week). This is a strong signal for the Bank of Canada to tightening and increase interest rates – in fact, the futures market has already priced in a 130 bps increase in interest rates. Because interest rate increases are like potato chips – you never eat just one (analogy from David Rosenberg).
Q4/2009 and Q1/2010 are the arguments for an increase in interest rates. However, looking at a few other macro data points:
- Manufacturing export volumes are 20% lower than they were in Q1/2008
- Unemployment is still around 8%
- Corporate bond spread are widening
- Inflation (CPI) is well within the “band”
- Producer prices are 1% lower than they were a year ago
- Raw material prices have dropped dramatically
- Canadian dollar is up 22% -- creating strong deflationary pressures on prices.
Canadian companies (like their American counterparts) saw Q1 profits surging back to pre crisis levels.
The table above excludes two segment, energy and financials, the reason is that the former pricing power is an externality to the Canadian economy, and the second, despite all the talk, financial institutions have been “making hay” out of the carry trade (borrow short and lend long to the government). The Canadian economy is in full recovery mode (V-Shape even). However, the bulk of this improvement has be cost driven as opposed to revenue driven (see the above on manufacturing), and profits pressures (especially on mining and transforming industry) will be under pressure as prices drop
However, there is another question: What is the Bank of Canada’s mission? In fact, price stability is its primary objective and although the BoC needs to be concerned about overheating of the economy (and our housing problem), interest rates are but one tool available to “readjust” the economy. Internal factors outweigh externalities, but the BoC can see the labor market as well as anyone else and at the current rate of job creation it will take another 40 months to reach the 5% unemployment level target.
My thesis remains unchanged, while the BoC can see many reasons to raise rates, there are many more than would seem to make a decision to stand pat attractive. Moreover, the BoC may want to telegraph to Bay Street Canada ’s Wall Street) that it is in Ottawa that rates policies are set, and not in Toronto
There is a tendency by market economists to look at specific data points as key factors (they may well have been in the past), and the exclusion of all other. Yes the Canadian economy was strong in the 4th and 1st quarter, but this is a recovery phase.
Even I was taken in when I saw the GDP growth for Q1/2010 – 6.1% is high, the housing market is strong (maybe too strong) and it’s a good reason to tighten. But, lets not forget other data points, unemployment, inflation targets and the deflationary impact of a strengthening Canadian dollar. The importance of each factor cannot be determined by when that data point was released (we tend to forget the earlier ones).
The one argument for tightening would be if producer prices were rising, and while the diffusion index was indicating that pricing points were rising, the reality is that PPI is actually down 1% on the year.
One final note from David Rosenberg:
The Canadian economy does not operate in a vacuum and we are not isolated from global events, as we saw in 2008 and early 2009. Even before the deflationary shock emanating from the European debt crisis, and even in the face of an economic rebound of its own, the Fed was stressing the need to maintain an accommodative policy stance because the future is highly uncertain — more than what is typical coming out of recession — and that this recovery is more fragile than meets the eye and vulnerable to a policy mistake. My hope is that the Bank doesn’t make one as it did in 2002 when it last tightened prematurely.
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