A number of positive significant economic and financial developments have occurred since the Monetary Policy Report Update on July. Among these are stronger economic growth and domestic demand, relatively stable inflation rate and a stronger Canadian dollar. However, there are also several negative developments which occurred. These include a weakened housing sector, tightening of credit conditions and realization of several risks identified in the July Update.
The Canadian economy has exhibited a stronger than projected growth from the last several months. Real GDP growth was 3.4 per cent in the second quarter. This is higher that the 2.8 per cent growth, which was projected in the July Update. This growth has been propelled largely by a stronger domestic demand, which caused the economy to operate further above its production potential. Growth in disposable income, a strong increase in household credit, and gains in household net worth are identified as other factors that contributed to the economic growth. Second, core inflation remains somewhere above the 2 percent target. It fell temporarily to 1.7 per cent in August, which reflected unexpected softness in the prices of some of the most volatile components of the index, particularly gasoline and natural gas. Strong domestic demand may be seen through rising costs of services, including shelter-related costs and food prices, especially for grains and oilseeds. Third, the Canadian dollar has grown stronger after the months of July and August. From its initial trading rates of 93 to 95.5 cents U.S., it has appreciated sharply to as high as US$1.03. This implies a more significant drag on the economy in 2008 and 2009 than previously expected. From this, it may be inferred that the Canadian economy will grow by 2.6 per cent in 2007, 2.3 per cent in 2008, and 2.5 per cent in 2009.
However, a weakened housing sector also presents the country with a weakened outlook for the U.S. economy. The Bank has revised down its projection for U.S. GDP growth to 1.9 per cent in 2007 and 2.1 per cent in 2008. U.S. growth is expected to pick up to 3 per cent in 2009. There has also been a tightening of credit conditions due to the greater-than-expected losses from U.S. subprime mortgages. These losses caused a global uncertainty as regards the valuations of structured products, a decline in investor appetite for risk, and increased demand for liquidity. For Canada, the Bank assumes that the cost of credit for firms and households relative to the overnight rate will be 25 basis points higher over the projection period than it was prior to the summer.
Considering all these, the Bank judges that the risks to its inflation projection are roughly balanced, with perhaps a slight tilt to the downside. The global economy is projected to grow somewhat more strongly in 2007 than projected in the July Update, before easing modestly in 2008 and 2009, as previously expected. A deeper and longer slowdown in domestic demand is expected, but lower U.S. interest rates should help to moderate weakness from the housing sector, and the real depreciation of the U.S. dollar should boost U.S. net exports. U.S. GDP growth is projected to pick up in 2009, although excess supply is projected to remain through to the end of that year. The increased drag from net exports caused a lowered projection for the second half of this year and for the first half of 2008 than that in July Update, which will result to a downward revision to the growth projection for U.S. GDP. However, net exports are expected to exert less drag on growth by 2009 due to the improvement in the U.S. economy. Economic growth in Canada is projected to average just over 2 per cent in the second half of 2007 and the first half of next year, before edging up to just below the growth rate of capacity by the beginning of 2009. The economy will remain in excess demand before returning to its production capacity in early 2009. The core rate of inflation is projected to remain above 2 per cent through mid-2008, then ease to 2 per cent and remain there through 2009. Total inflation will rise sharply to about 3 per cent in the fourth quarter, then move back down to the 2 per cent target in the second half of 2008, where it remains over the rest of the projection period.