It appears that the Bank of Canada is having second thoughts about the economy’s overall health. After cutting its forecast of Gross Domestic Product (GDP) change for 2009 from -1.2% to -3.0% in its April 2009 Monetary Policy Report (MPR), the Bank (in its July 2009 MPR) now expects that the economy will contract by 2.3% in 2009. The Bank also thinks that economic growth in 2010 will be a bit stronger (+3.0%) than it did in April (+2.5%), but not quite as strong as it thought it would be back in January (+3.8%).

The major reasons that the Bank gives for its more upbeat outlook are better domestic financial conditions and higher levels of both business and consumer confidence. These factors caused growth in the first half of the year to be stronger than anticipated. In view of the fact that the economy slowed less than it expected in the first half of the year, the Bank now sees the recovery beginning in the current (third) quarter, approximately three months sooner than it did in April.

Consistent with its upward revision to growth this year and next, the Bank of Canada projects that the gap between actual and potential output (i.e., the output gap) is not as large as previously estimated and as a result the core rate of inflation will hit +2.0% in the second quarter of 2011, three months sooner than it expected in April. The core inflation rate omits eight of the most highly volatile components of the all-items Consumer Price Index. The core rate is used by the Bank of Canada to target monetary policy.

Looking ahead, the unexpected strength of recent economic statistics in both Canada and in the United States suggests that the pace of recovery in both countries is going to be stronger than the Bank is currently expecting. This increases the probability that the Bank will be forced to adopt a more restrictive policy stance and start to raise interest rates in the first half of 2010.