BOC Withholds From Signaling Tightening

Recent headwind in global economic outlook should deter BOC's tightening schedule. We believe the central bank will leave the policy rate unchanged at 1% in September. Indeed, Fed's decision to keep interest rates at exceptionally low levels at least until mid-2013 and the increasing downside risks to inflation signaled the BOC will leave the overnight rate unchanged at least until mid -2012. That said, it's also unlikely for the central bank to trim interest rates as headline inflation remains high and the job market is robust.

GDP contracted -0.4% q/q in 2Q11, following a downwardly revised +3.6% expansion in the prior quarter as deterioration in US economy dampened exports. Domestically, growth remained strong with business investment and household spending showing decent growths during the quarter. Headline inflation eased to +2.7% in July, from 3.1% in June and +3.1% in May, due to lower energy costs and changes in tax policy. Yet, inflation stayed at the upper limit for BOC's target. Core CPI rose to +1.6% in July from +1.3% in June. Employment increased only +7K in July after growing more than +20K in each of the past 3 months but the positive sign came from full-time payrolls which continued to rise. The jobless rate slid to 7.2% from 7.4% in June and May.

At the opening statement before the House of Commons Standing Committee on Finance, BOC Governor Mark Carney said that several downside risks, such as the intensified Eurozone sovereign crisis, the downgrade of US credit rating and weakness in macroeconomic data, to the central bank's July MPR projection have been realized. While the spillovers to the Canadian financial markets have been less 'pronounced', the impacts are still 'notable'. Carney stated that 'the considerable external headwinds' are now 'blowing harder' and Canada will have to adapt to a world that is 'awash with debt' and it will 'take years' for the balance sheets to be repaired. As a result, risks to inflation have also skewed to the downgrade as a result of 'somewhat weaker economic momentum globally'. Yet, it reminded us that growth will continue with acceleration being seen in the second half of the year, led by business investment and household expenditures.

We expect the BOC will deliver a less hawkish statement in September. In the July meeting, the central bank stated that 'some of the considerable monetary policy stimulus currently in place will be withdrawn'. That appeared to be more hawkish than the May statement which stated ''some of the considerable monetary policy stimulus currently in place will be eventually withdrawn'. The BOC this month may withhold the tightening rhetoric as policymakers may prefer to gather more information regarding global economic developments.

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A Few Doves Favored More Easing Than Just A Guideline On Fed Funds Rate

The minutes of the August FOMC meeting unveiled that a few members believed the Fed should have done more at the meeting, given the economic developments. The range of tools that policymakers discussed to stimulate the economy included reinforcing forward guidance about the likely path of monetary policy, additional asset purchases, increasing the average maturity of securities holdings, reducing the interest rate paid on excess reserve balances. However, the preference of the above tools was not shown. Information received during the intermeeting period had led the staff to revise down the projection for real GDP growth in the second half of 2011 and in 2012 'notably'. Concerning inflation, policymakers believed headline inflation has 'moderated' as 'prices of energy and some commodities have declined from their earlier peaks'.

As the minutes stated, 'a few members' preferred 'a more substantial move at this meeting'. Some members favored additional easing as they expected 'the unemployment rate to remain well above, and inflation to be at or below, levels consistent with the Committee's mandate. However, they were willing to accept 'the stronger forward guidance as a step in the direction of additional accommodation' as this was 'a measured response to the deterioration in the outlook over the intermeeting period'. In choosing the time horizon of 'at least through mid-2013', members also considered 'conditioning the outlook' for the Fed funds rate on 'explicit numerical values for the unemployment rate or the inflation rate'. While some members said that stating an explicit time horizon would 'establish greater clarity regarding the Fed's intentions and its likely reaction to future economic developments', others questioned about 'how an appropriate numerical value might be chosen'.

Policymakers did not show preference on the stimulating tools but they 'agreed that the September meeting should be extended to two days' as more time is needed for discussion. Among the tools, we believe lengthening the duration of securities holdings would be preferable currently as it would lower longer term interest rates without needing to boost the size of the Fed's balance sheet.

As far as the economic outlook is concerned, most members downgraded their forecasts after taking information during the intermeeting period into account. In particular, the lower estimates of real GDP in recent years that were contained in the annual revisions to the NIPA led the staff to lower its estimate of potential GDP growth, both during recent years and over the forecast period, and to mark down further the staff forecast. Moreover, a 'couple of participants' worried that the 'exceptionally high level of long-term unemployment' could lead to 'permanent negative effects on the skills and employment prospects of those affected'. Concerning inflation, the members 'continued to expect prices to rise at a subdued pace in 2012'.

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Central Bank Forecasts: ECB Remains on Hold Through 2012

After rate hikes in April and July (each by +25 bps), ECB's main refinancing rate is now at 1.5%. We expect the central bank will remain on hold through 2012 given weakened growth and inflation outlook. Recent macroeconomic data have been disappointing. Eurozone's GDP growth eased to +0.2% q/q in 2Q11 from +0.8% in the prior quarter. Germany's economy expanded only +0.1% q/q while growth in France stalled. Manufacturing activities have shown signs of fatigue with manufacturing PMI slipping to 49.7 in August from 50.4 a month ago. while consumer confidence soured as there's no way out for the sovereign debt crisis. ZEW's survey showed that Eurozone's economic sentiment tumbled to -40 in August from -7 a month ago. The market had expected a pickup to -6.2. The index for Germany alone plunged to -37.6 from -15.1. Fiscal consolidative measures in debt-ridden economies will also weigh on growth. Diminishing inflationary pressures due to global economy downturn and easing commodity prices also make the central bank more comfortable in putting interest rates on hold. Tight fiscal and accommodative monetary stances will be the region's policy mix in coming years.

We currently expect Eurozone's GDP to grow +1.8% in 2011 before slowing to +1% in 2012. On annual basis, economic growth was as strong as +2.5% in 1Q11 but then deteriorated to +1.7% in 2Q11. Given the weaker prospect In global economic activities, the 17-nation region's exports will be hurt in the second half of the year. Together with domestic issues such as fiscal tightening and loss in consumer confidence which would result in shrinking household spending, Eurozone's outlook will be significantly weaker in the second half than the first half. Indeed, risks to our growth forecasts are skewed to the downside. Indeed, Both Morgan Stanley and Deutsche Bank trimmed their estimates to +1.7% for 2011 and +0.5% for 2012 last week.

Inflation moderated to +2.5% in July from +2.7% in June but remained above ECB's target of 'below, but close to, 2%'. High energy and food remained the key upward price pressures. In the second half of the year, inflationary pressures may ease as domestic demand weakens. Moreover, geopolitical turmoil in Libya is about to come to an end. This would resume the country's oil supply and alleviate the pressure coming from oil prices.

While we expect the ECB will keep interest rates low given moderating inflationary pressures and sovereign debt problems in the European periphery, it has few measures left to stimulate economic growth. The central bank may adopt rate cuts of -50 bps, thus return the policy rate to the unprecedented level of 1%. As far as non-standard measures are concerned, full allotments of LTROs and MROs remained in place. The ECB announced at the August meeting, Full allotment of fixed rate MROs will be continued for 'as long as necessary'.

President Trichet also signaled at the press conference that the Securities Market Program (SMP) has been re-activated. According to the latest report, the settled 14.29B euro in purchases of government bonds in SMP in the week ended August 19. This compared with the purchase of 22B euro in the prior week when the program was 'resumed' to stabilize Spanish and Italian bond yields. The ECB said it will drain 110.5B euro from the market at its weekly auction of one-week deposits. We expect the program will continue even after the EFSF has started operation. Given the small size of the EFSF, it may have limited capability to intervene through secondary purchases.

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BOE Voted Unanimously To Keep Rates Unchanged, First Time Since May 2010

The BOE minutes for the August meeting turned out to be more dovish than expected as 2 hawks, Spencer Dale and Martin Weale, stopped pushing for a rate hike, making the decision to hold the Bank Rate unchanged at 0.5% unanimous for the first time since May 2010. Adam Posen continued to favor expanding the asset-buying program by +50B pound to 250B pounds. The pound slid after the minutes as it's increasingly likely that the central bank will adopt further easing.

Policymakers acknowledged the slowdown in economic activities with the greatest downside risk coming from the Eurozone. As mentioned in the minutes, 'evidence of slowing activity, and more particularly, concerns about fiscal policy in the U.S. and the substantial challenges faced by the euro area, had resulted in stressed conditions in financial markets' and 'news over the month had generally reinforced the weak tone of indicators of global activity growth over the past few months'. Indeed, the BOE revised lower the growth forecasts for the UK in light of the current headwind.

It's rather unexpected that the Committee voted unanimously for the first time in more than a year to keep interest rates unchanged. Spencer Dale and Martin Weale, who had favored a rate hike of +25 bps, voted to maintain the Bank Rate at 0.5%. According to the minutes, the 2 members 'remained particularly concerned about risks to the upside associated with a sustained period of above-target inflation'. However, recent developments had 'weakened' the case of tightening.

As far as the asset-buying program is concerned, the minutes unveiled that some members 'considered whether there was a case for increasing' the size. However, the conclusion was that there 'was not yet strong enough' evidence to support the move. Policymakers stated that further increase in the size might 'become warranted were some of the downside risks to materialize'. Adam Posen retained the view that 'the balance of risks to inflation continued to warrant an immediate expansion' of asset purchases. Posen believed that the weak pattern of demand domestically and overseas had evolved broadly as expected…There remained a significant margin of spare capacity' and it's like that 'inflation would fall below the target in the medium-term'.

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Central Bank Forecasts: BOJ's Stance To Remain Accommodative After The New PM

We don't expect the monetary policy in Japan will change after the new Prime Minister on board. With economic growth remaining sluggish and deflation still a threat, the BOJ will leave the policy rate at virtually 0% at least until 2012. The central bank will also maintain the asset-purchase program and may expand the scope of assets if necessary. With regard to yen's strength, we believe the government has not given up intervention though the impacts so far have not been significant.

Yoshihiko Noda has been elected as Japan's new Prime Minister. The former Finance Minister will be the 6th PM in 5 years. It is expected that Noda will continue the policies adopted when he served as the Finance Minister. Therefore, his succession would probably give the market a sense of stability. There are a series of issues that Noda has to deal with as the new PM: reconstruction works after the Great East Japan Earthquake in March, the change of energy policy after the nuclear crisis that followed the earthquake and tsunami, the recovery of Japanese economic growth and the control of excessive yen appreciation. As far as economic policies are concerns, we believe the mix of fiscal and monetary policies will remain accommodative in the new regime. Being described as a fiscal conservative, Noda suggested doubling the 5% sales tax to fund disaster reconstruction. However, he has toned down this proposal recently. BOJ's independence will unlikely improve and monetary policies will remain accommodative in coming years.

We expect the policy rate, the uncollateralized overnight call rate, will stay at around 0-0.1% through 2012 as Japan's economy has remained fragile and the risk of deflation is still high. The preliminary estimate showed that Japan's economy contracted -0.3% q/q in 2Q11. While it was better than expected, it was mainly helped by government spending and household consumption actually contracted for the 3rd consecutive quarter. Deflation remained a concern in Japan. Although the nationwide CPI (excluding perishables) rose +0.1% q/q in July while the reading excluding food and energy dipped -0.5%, it remained well-below BOJ's target inflation of +1% y/y.

Since 2008, the BOJ has been expanding easing actions, hoping to revive the economy and curb yen's appreciation. In December 2009, the BOJ cut the policy rate from 0.3% to 0.1%. At the same time, it increased the size of outright purchases of JGBs from 14.4 trillion yen to 16.8 trillion yen as well as expanded the range of JGBs accepted in outright purchases. In 2009, it further increased the size of outright purchases of JGBs to 21.6 trillion yen from 16.8 trillion yen in March and introduced 3-month fixed-rated funding operations in December. In August 2010, the BOJ expanded the scope of fixed-rate operations to 6 months. In October, the policy rate was lowered to 0-0.1%. The central bank at the same time established the asset purchase program to buy 2-year JGBs, commercial papers, J-Reits and other assets. The program was expanded twice (March and August) so far this year to stimulate the economy and to curb yen's strength.

Strength in Japanese yen has been a headache for policymakers as it hurts the country's export-oriented economy. The government has adopted intervention for several times but the impacts have been temporary. Last week, the government introduced a new loan facility worth of $100B to encourage domestic companies to invest overseas. The scheme, which will be in effect for 1 year, is expected to weaken the yen as Japanese companies exchange yen for foreign currency to invest overseas. While the measures may help boost the economy and send the currency lower, the impacts are limited. In his capacity as the Finance Minister, Noda had taken firm steps to intervene against appreciation in Japanese yen. He said last month that he would take 'bold' action to curb yen's appreciation and intervention 'is a measure of last resort -- it would be meaningless if it were not a surprise'. Therefore, we believe currency intervention is still on the government's agenda with Noda as the new PM.

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BoC Leaves Overnight Rate Unchanged, Removes Tightening Rhetoric

As expected, the BOC decided to leave the overnight rate unchanged at 1% and correspondingly, Bank Rate and the deposit rate at 1.25% and 0.75% respectively. The accompanying statement delivered a less hawkish tone than before. As global economic has deteriorated in recent weeks and total CPI inflation will continue to moderate as temporary factors unwind, the central bank believed the need to withdraw monetary policy stimulus has 'diminished'.

The BOC listed a series of events that has caused the recent instability in the economy and financial markets. The European sovereign debt crisis has intensified and 'significant initiatives by European authorities' are needed to resolve the 'acute fiscal and financial strains'. Economic indicators suggested the risk of US recession heightened and fiscal stimulus in the country will 'soon turn into material fiscal drag'. Growth in emerging markets will inevitably be dragged down by weakness in advanced economies.

In Canada, growth eased in 2Q11 as driven by temporary factors and the central bank remained confident that growth will resume in the second half. However, persistent strength of the Canadian dollar will affect net exports which are 'expected to remain a major source of weakness, reflecting more modest global demand and ongoing competitiveness challenges'. Concerning inflation, The BOC expected inflation will ease as high food and energy prices moderate. Yet, the central bank at the same time warned that while 'commodity prices have declined owing to diminished global growth prospects, they remain relatively high'.

Concerning monetary policy, the central bank removed the reference that 'to the extent that the expansion continues and the current material excess supply in the economy is gradually absorbed, some of the considerable monetary policy stimulus currently in place will be withdrawn'. Instead, it stated 'in light of slowing global economic momentum and heightened financial uncertainty, the need to withdraw monetary policy stimulus has diminished'. The meeting outcome was largely in line with our expectation. We retain our view that the BOC will leave the policy rate unchanged at least until mid-2012.