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meeting, the central bank stated that 'some of the considerable monetary policy stimulus currently in place will be withdrawn'.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.