Bank of Canada holds central rate steady

The Bank of Canada held its benchmark overnight lending rate steady at 4.25 per cent on October 17th. The trend-setting Bank rate, which is set 0.25 percentage points above the overnight lending rate, remains at 4.5 per cent. CREA expects interest rates to remain on hold over the rest of the year.

The rate was raised seven times by 0.25 per cent from September 2005 until it was put on hold in July 2006. “The current level of the target for the overnight rate is judged at this time to be consistent with achieving the inflation target over the medium term,” said the Bank in its October statement. This is the same statement the Bank made in both July and September.

The Bank again revised its forecast for economic growth downward. The statement regarding the most recent decision to hold interest rates steady acknowledged that economic growth in the second and third quarters of 2006 has been weaker than expected – largely because of weaker exports. Assessing current interest rate levels, the Bank says it “judges that the Canadian economy continues to operate just above its production capacity.”

Upward pressure on inflation normally eases when current economic growth comes in weaker than previous Bank of Canada forecasts, and below what the Bank considers to be its full potential. In the October statement, the Bank lowered the forecast for economic growth for this year and for 2007. It also lowered the bar for potential economic growth.

With a lower forecast for potential output, the Bank was able to lower its projection for economic growth and still characterize the economy as operating close to its productive capacity. The Bank currently estimates that the Canadian economy is in a position of slight excess demand, which will gradually be eroded as economic growth slows through the end of 2007.

“The bottom line is that the Bank sees interest rates as not too high, not too low, but just right,” said CREA Chief Economist Gregory Klump. Looking ahead, the Bank repeated its assessment of risks to the outlook for inflation that it published in September. “The main upside risk relates to the momentum in household spending and housing prices. The main downside risk is that the U.S. economy could slow more sharply than expected, leading to lower Canadian exports.” In the Bank's view, those risks have increased but remain “roughly balanced”.

“If the Canadian economy remains consistent with the Bank of Canada's forecast, interest rates will remain on hold indefinitely,” said Klump. “Inflation is in sync with the Bank's expectations. This could change during the period leading up to its next meeting in December, when it again sets its trend-setting overnight lending rate.”

“Economic growth is being supported by continuing strength in domestic demand, while being undercut by weakness in net trade. Slowing U.S. economic growth will likely tip the balance, and translate into a cut in interest rates of 0.5 per cent in the first half of next year,” Klump noted.

Bonds respond to expectations about inflation and economic growth, and mortgage rates track bond yields. “The bond market already priced in a downshift in economic growth due to weakening Canadian exports to the U.S,” said Klump. “That caused the five year conventional mortgage to peak in August. Recent economic reports suggest that the bond market may have gotten ahead of itself in pricing in interest rate cuts next year. The five year conventional mortgage rate may rebound slightly in October or November, but remain below seven per cent over the rest of this year.”

When the bank rate was hiked on October 17th, the advertised conventional five-year conventional mortgage rate stood at 6.6 per cent – down 35 basis points compared to mid-August. (One basis point equals one one-hundredth of a percentage point). Competition among mortgage lenders remains stiff, which continues to help many borrowers negotiate discounts of one per cent or more off advertised rates.

“An increase in new listings and recent home price increases are expected to continue to prompt some homebuyers to take more time to shop before buying and gradually cool sales activity over the rest of the year and in 2007, but not by much,” Klump added.

Record level sales activity in the first nine months of 2006 is expected to help lift MLS® residential transactions to their sixth annual record in 2006, while additional price increases are forecast to push the MLS® residential average price to the highest level on record. (CREA 17/10/2006)