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• The Bank of Canada (BoC) elected to leave its overnight interest rate target unchanged at 1.00%, as markets anticipated.

• In line with data that have tended to disappoint since the second quarter, the accompanying communiqué acknowledged the recovery has been softer than expected. Their statement noted that while it “expects that private demand in advanced economies will become sufficiently entrenched to sustain the recovery, the combination of difficult labour market dynamics and ongoing deleveraging in many advanced economies is expected to moderate the pace of growth relative to prior expectations”.

• Compared to its July forecasts of 3.5% and 2.9% growth in Canada in 2010 and 2011 respectively, the BoC shaved this down to 3.0% and 2.3%. The 2011 forecast is a marked downgrade and closer than expected to our own 2.0% forecast. The growth forecast for 2012 was upgraded from 2.2% to 2.6%. As a result of the downgraded view for 2010/11, the BoC “judges that the output gap is slightly larger and that the economy will return to full capacity by the end of 2012 rather than the beginning of that year, as had been anticipated in July”. A more detailed forecast will be provided tomorrow in the BoC’s Monetary Policy Report (MPR).

• As for near-term policy guidance, the very much open-ended statement that “any further reduction in monetary policy stimulus would need to be carefully considered” was preserved.

Key Implications

• Now that the BoC has paused, the key question has become: for how long? In turn, this will mostly depend on how the U.S. and Canadian recoveries unfold in the near-term.

• Canadian inflation has been a tad softer than expected in July, but not so much so as to justify an extended pause at a level of the overnight rate which is still negative in real (inflation-adjusted) terms. In others words, softer inflation is not the factor driving the BoC to the sidelines, nor is stronger inflation likely to be the immediate trigger behind a renewed hiking cycle.

• Although its magnitude and impact are uncertain, a second round of quantitative easing (QE2) from the U.S. Federal Reserve in early November has become more likely than not. Expectations for an even more accommodative U.S. monetary policy have pushed up the CAD in the process. In this setting, the BoC would likely be uncomfortable with further tightening, which would propel the CAD even higher.

• The December and January meetings appear too early post-QE2 to get a clear enough picture of its traction on the U.S. economy. This makes the March 1st 2011 meeting the most likely for the next BoC hike. By then, the BoC will have had time to digest economic data for the second half of this year and will also see how 2011 is starting off. The sustainability of the North American recovery, albeit soft, should be clear enough to resume interest rate hikes. In the interim, do not look for the BoC to hint at how long it may stand pat, for fear of reigniting a surge in credit demand. It will, however, be eager to signal its next hike at the first opportunity provided by strong enough economic data. We expected the overnight rate to reach 2.00% by the end of 2011.

Provided by TD Economics – Pascal Gauthier, Senior Economist