| |
May 2008
Download full report (PDF)
Fed and Bank of Canada signal that the end of easing cycle is near
The Fed and the Bank of Canada appear to have shifted into data-watching mode following the 25 basis-point ease in the United States and the Bank of Canada’s 50 basis-point slice to the overnight rate in April. The Fed’s policy statement suggested that committee members view the cumulative 325 basis points of easing plus non rate-related liquidity measures as providing the foundation for financial markets to function and the economy to recover. The statement did not signal a definitive end to rate cuts but more of a switch to a “wait and see” stance.
While no significant pick-up in growth is expected in the near-term, the statement sets the Fed up to ride out this period with the policy rate steady at the current 2% in the near-term. Risks that the economy will falter again late in the year following the tax rebate-induced spurt expected in the third quarter will likely see the Fed restart its rate cut program. We look for 50 basis points of easing in the fourth quarter and the funds rate at a cyclical low of 1.5%. Our year-end Fed funds target is unchanged from our previous forecast, but we have adjusted the timing of the Fed’s actions to reflect their updated stance.
The Bank of Canada's statement also maintained an easing bias, but there was a softened tone about the timing and necessity of future rate cuts. We are sticking with our forecast that the Bank of Canada will hold the overnight rate steady at 3% at the June fixed action date but that it will make a final 25 basis-point insurance cut in July in the face of indications of declining U.S. economic activity in order to prevent this weakness from spilling over to the Canadian economy.
Signs emerging that financial markets are stabilizing
- Financial markets may be finding their footing as credit spreads are starting to retrace, while equity markets showed greater strength in April, with the financial indices in Canada and the United States posting a solid 12% gain since the Fed’s actions mid-March.
- While financial markets appear to be calming down a bit, the news on the U.S. economy remains volatile. The economy eked out a marginal 0.6% annualized gain in the first quarter, matching the fourth quarter’s increase and marking the weakest two-quarter average growth rate since 2001.
- However, the prospect of calmer financial markets bodes well for an easing in credit conditions, which is positive for the U.S. growth story in the second half of 2008 with additional support coming from the government’s fiscal stimulus package. Our forecast assumes that, by the third quarter, Fed actions to date and the fiscal stimulus package will be to some degree successful and that the economy will grow by 2.9% before slowing to 1.2% in the fourth.
- We expect that the moderation in the pace of economic growth in the fourth quarter will be the catalyst for the Fed to trim back the funds rate but that it will limit the amount of “insurance” easing to 50 basis points.
Sub-par growth to prompt an “insurance” ease by the Bank of Canada
- The Bank of Canada has updated its economic growth forecast and now looks for a bigger trade drag and slower consumer and business spending this year. We expect the economy to grow by 1.6% this year and 2.3% in 2009. This justified their aggressive 50 basis-point cut to the overnight rate announced April 22.
- Inflation is not a problem with both the core and all-items rates near the low end of the Bank of Canada’s target band, giving it leeway to keep policy geared toward mitigating the downside risks to Canada’s economy coming from the steady weakening in the pace of U.S. growth and the rising cost of capital.
- February’s unexpected decline in GDP suggests that the economy’s momentum is fading a bit and will likely cause the Bank to ease the policy rate as an “insurance” policy against a more substantive weakening. The Bank is likely to finish its easing cycle with another 25 basis-point move in July.
|
|
