Target Overnight Rate Stays at 3.00%

Yesterday (June 10, 2008), the Bank of Canada (BOC) surprised many analysts by holding its key policy-setting interest rate, the target overnight rate, steady at 3.00%. The consensus forecast had been for a 25 basis point (100 basis points = 1.00%) cut. Many have taken the “no change” approach to mean that the BOC is growing increasingly concerned about inflation. However, the year-over-year increase in Canada’s Consumer Price Index (CPI) is currently only 1.7% and the core rate is 1.4%.

Inflation is a growing problem around the world, due to strong demand for food and energy, and the nuisance factor of speculators driving up prices. In the United States, inflation currently running at 3.9% is certainly a concern. Up to this point in time, however, slow economic growth in both countries has taken precedence over fighting inflation when it comes to monetary action. Now, the BOC has considered the options and cannot see how lowering interest rates will contribute much to the overall economy.

Final Domestic Demand in Canada +2.3%

Canada’s real Gross Domestic Product (GDP) growth in the first quarter was negative (-0.3%) for the first time since the second quarter of 2003, but there was not that much wrong with the domestic economy. The two problems that caused the overall weakness were weak foreign trade and a very large inventory adjustment. Final domestic demand is a measure that omits these two factors and only looks at personal and government consumption and business and government investment. The annualized rate of increase for this measure in first-quarter 2008 was a quite respectable +2.3%.

Zero Growth in U.S. Domestic Demand over Past Two Quarters

In the U.S., the large inventory adjustment came in the final quarter of 2007 and exports performed much better than imports in first-quarter 2008. The effect was to yield a GDP growth figure of +0.9% in the January through March period. However, U.S. final domestic demand in both fourth-quarter 2007 and first-quarter 2008 was 0.0%. The U.S. domestic economy has already experienced two quarters of zero real growth. Forget the headline numbers; Canada’s domestic economy is continuing to outperform the U.S.

The Three Real Reasons to Stand Pat on Interest Rates

Canada’s foreign trade has been wounded by the climb in value of the Canadian dollar versus the U.S. dollar on a long-term basis. This will eventually sort itself out, but for the moment, a lowering of interest rates would only exacerbate the problem. This is one of the reasons that the BOC left interest rates where they are.

Also, at +2.3% for final domestic demand, more stimulus is not really warranted at this time. Finally, the Federal Reserve’s Open Market Committee will meet on June 25 to set U.S. interest rate policy. With a federal funds rate at only 2.00%, it would seem unlikely that any downward action will be taken by the Fed either. The bottom line is that the Bank of Canada probably sees no good reason to lower interest rates at this time.

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