Hilights
- The Canadian economy has moved up near its production capacity sooner than was projected.
- The Canadian economy is projected to remain near its production capacity through to the end of 2006—growing by slightly less than 3 per cent in 2005 and by slightly more than 3 per cent in 2006.
- Core inflation is projected to move up to 2 per cent by the end of 2005.
- This base-case projection assumes further reduction of monetary stimulus over time to keep the economy near its production capacity and achieve the inflation target.
- There are significant risks and uncertainties around this base case related to the adjustment to global developments.
Overview
The Canadian economy continues to adjust to major global developments. These include a marked recovery in world economic growth and an associated increase in commodity prices; the growing global presence of major emerging-market economies, such as China and India; and a realignment of world currencies, including the Canadian dollar. Canadian monetary policy is facilitating the adjustment by aiming to keep inflation at its 2 per cent target and the economy operating near its production capacity.Early in the year, with core inflation below target and excess supply in the economy, the Bank lowered its target for the overnight interest rate to 2 per cent to support growth in domestic demand. Given the appreciation of the Canadian dollar in 2003, the Bank did not expect net exports (the difference between exports and imports) to make a material contribution to growth in aggregate demand in 2004 and 2005. But, in fact, in the first half of this year, exports grew much more vigorously than anticipated. As a result, the Canadian economy has moved up near its production capacity sooner than was projected in either the April Monetary Policy Report or the July Update.
Recent developments have reinforced the continuing need for economic adjustments in Canada. Largely reflecting the strength of global demand, world oil prices have risen well above the Bank's earlier assumptions. The prices of non-energy commodities are at high levels, and the Canadian dollar has strengthened further, which places additional pressure on some sectors that are highly exposed to international trade.
Over the period to the end of 2006, the Bank's base-case projection is for aggregate demand for Canadian goods and services to expand, on average, at about the same rate as potential output, which is estimated at 3 per cent. Given the effects of higher oil prices and the past appreciation of the Canadian dollar, the Bank projects growth to be slightly less than 3 per cent in 2005 and slightly more than 3 per cent in 2006.
With the economy expected to remain near its production capacity throughout the projection period, core inflation is projected to move back up to 2 per cent by the end of 2005.
Against this background, the Bank moved to reduce the amount of monetary stimulus in the economy by raising its target for the overnight rate to 2.25 per cent on 8 September and to 2.50 per cent on 19 October. Further reduction of monetary stimulus will be required over time to keep inflation on target, with the pace of interest rate increases depending on the Bank's continuing assessment of the prospects for factors that affect pressures on capacity and, hence, inflation.
The outlook for Canadian exports and imports is of particular significance in this respect, given the uncertainty associated with the ongoing adjustments to changes in the global economy, including changes in commodity prices and exchange rates. The risks surrounding global economic prospects relate primarily to the evolution of oil prices, the pace of expansion in China, the way in which current account imbalances in the United States and East Asia will be resolved, and geopolitical developments.
