In Canada, the widely anticipated June 1st fixed an­nouncement date finally arrived this week. And while the probability of a rate hike was thought to be only marginally above 50%, the Bank of Canada (BoC) decided to begin its tightening cycle, and raised the overnight rate by 25 basis points to 0.50%. Tempering expectations of future hikes and leaving itself plenty of room to maneuver, the central bank emphasized the uncertainty surrounding the global economic outlook.

Indeed, the BoC noted that the global recovery, while progressing, is uneven across countries, and that the nec­essary rebalancing of global growth has yet to take place. Moreover, it stated that the rebound in most advanced na­tions is still heavily reliant on fiscal and monetary stimulus. But the central bank also pointed out that while the turbu­lence in Europe presents some downside risks for the global recovery, spillover into Canada has thus far been “limited to a modest fall in commodity prices and some tightening in financial conditions”. As such, the recovery in economic activity and inflation in Canada have been unfolding largely as expected.

Real GDP for the first quarter was released a day before the rate decision, and provided strong support for a rate hike. The report revealed that the Canadian economy advanced at a stellar 6.1% Q/Q annualized rate, which comes off the heels of a robust 4.9% pace seen in the fourth quarter of 2009. The largest contributions to growth stemmed from domestic demand, with residential investment up by a whopping 24% and consumer spending up 4%. As well, business investment expanded by 0.9%, following a sharp 9% drop in the quarter prior. This provides a strong handoff for overall growth in the second quarter of the year, which we anticipate will come in around 4%. But going forward, economic activity will likely ease, as the housing market cools and consumer spending moves more in line with in­come growth. As such, we expect real GDP growth to fall in the 2.5-3.0% range in the second half of 2010 – roughly half that estimated for the first half of the year.

The uptrend in the labour market has also presented a strong case for a tightening in monetary policy, and this morning’s employment report was no exception. The Cana­dian economy created nearly 25,000 jobs in May, following the incredible 109,000 positions added in April. What’s more, the bulk of the gains in May came from full-time, private sector employment, suggesting that the underlying fundamentals in the labour market are quite robust. While the unemployment rate remained unchanged at 8.1% in May, due to more people entering the labour force, we expect ongoing job creation to average about 20,000 positions per month going forward, which should be sufficient to bring that rate down to 7.5% by the end of 2011.

The economic data to date is certainly encouraging of a further reduction in monetary stimulus. But while the Bank of Canada has begun the process, there is still a great deal of uncertainty surrounding monetary policy going forward. The tone of the communiqué accompanying the rate decision was quite dovish, and provided no guidance for the timing of future rate hikes. The BoC stated that “given the con­siderable uncertainty surrounding the outlook, any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic develop­ments”, suggesting that future decisions will be heavily influenced by the data and events that take place between now and each decision date. Furthermore, when individual hikes do occur, they are likely to remain of the quarter-point fare rather than anything larger. Nonetheless, given that interest rates are still extremely accommodative, and that the domestic economy continues to charge ahead, we expect the BoC to continue its tightening cycle at a measured pace, with the overnight rate reaching 1.50% by year-end.

Dina Cover, Economist

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