Business News Network – April 13, 2011

The strength of the Canadian dollar is turning Canada’s economic performance into a boomerang, with the recent growth spurt giving way to a gradually slower pace that could persist for years as a currency well north of parity restrains exports.

In its quarterly monetary policy report Wednesday, the Bank of Canada suggested that the risk of “greater headwinds” from the loonie gives policy makers more time before inflation is an issue, even as it said the slack from the recession will be absorbed by mid-2012, six months sooner than anticipated.

While that new timeline would normally imply a faster-than-planned path to higher borrowing costs, the central bank’s focus on the loonie suggests the next interest rate hike may be farther away than many were predicting.

“The stronger economic expansion observed in recent quarters is projected to give way to a more modest pace, as the particularly strong rebound in exports observed recently is unlikely to be sustained, given ongoing competitive challenges including headwinds from the Candian dollar,” the central bank said. “The recovery in exports will be subdued relative to earlier global recoveries.”

Though the central bank sees faster Canadian growth this year than it did in January – upping its 2011 projection to 2.9 percent from 2.4 percent – much of that increase is explained by a 4.2-percent expansion from January through March, on an annual basis, capping the momentum carried into the year by a 3.3-percent growth rate in the last quarter of 2010. Those impressive results were due in large part to a surge in exports which, it is now increasingly clear, has not continued.

The current quarter will see a significant slowdown to a 2-percent pace of growth, the central bank said, a rate that would be closer to 2.5 percent without the Japanese earthquake’s estimated impact on North American supply chains. Growth will then pick up, while remaining below 3 percent and gradually slipping to just above 2 percent by the end of 2012.

All told, growth in 2012 will come in a bit lower than what the bank predicted in January, at 2.6 percent instead of 2.8 percent.

The currency is helping to keep a lid on inflation by making imports cheaper for Canadians, including for firms actively working to boost productivity by purchasing state-of-the-art machinery from foreign suppliers. But it is also making Canadian goods and services more expensive abroad, cutting into companies’ ability to crack new markets in a fiercely competitive post-downturn global economy.

The central bank, which in January listed for the first time in memory a currency at parity with the U.S. dollar as one of the “assumptions’’ behind its forecast, said the latest projections factor in a loonie trading at an average level of $1.03 (US). While that is not a prediction per se, it is factored into the bank’s forecasts for growth and inflation through to the end of 2013.

Wednesday’s report also assumes that oil will trade above $100 (US) a barrel throughout the projection period, and at $109 (US) per barrel for three quarters starting with the second half of this year, as well as “persistently strong’’ prices for non-energy commodities, all of which fuels the loonie since Canada is a key producing nation.

At the same time, while commodity prices are causing global inflation pressures to increase, and even as Canadians chafe at higher gasoline and food costs, the central bank’s preferred measure – which strips out volatile items such as fresh fruit and energy – has been dropping. The so-called core rate will rise “gradually” to the bank’s 2-percent goal by mid-2012, policy makers said, suggesting little meaningful inflationary pressure until then.

The central bank acknowledged that its latest survey of Canadian businesses showed a growing number of companies bracing for hotter inflation in coming months – expectations which, in some cases, are already translating into higher prices for consumers. But policy makers rightly pointed out that the survey also found the share of firms having trouble filling open positions “remains well below historical averages,’’ in keeping with a 7.7-percent unemployment rate and a slow recovery in hours worked.

All of which suggests wages, often the biggest driver of inflation, won’t take off anytime soon.

The global recovery is “becoming more firmly entrenched,’’ the bank said, as growth in the United States solidifies, the European expansion strengthens, and global financial conditions “remain very stimulative and investors have become noticeably less risk averse.’’ The world economy will grow 4.1 percent this year, one tick higher than the central bank’s January forecast of 4 percent, and 3.9 percent in 2012.

The central bank cut its outlook slightly for the United States, while expressing optimism that the rebound in Canada’s main export market is solidifying as businesses invest and the labour market recovers, despite an “acutely challenged’’ housing market and efforts by households and governments to trim debt. The U.S. economy will expand 3 percent this year instead of 3.3 percent, the bank said, maintaining its 3.2 percent call for 2012.

Policy makers remain concerned about the sovereign-debt troubles in Europe, but nonetheless boosted their projections for the euro area for this year and next, to 1.8 percent and 1.7 percent compared with their January prediction of 1.5 percent in both years.

For Canada, inflation could be quicker if commodity prices are higher than expected due to rapidly growing emerging markets failing to keep their economies from overheating, or if Canadian households spend more than anticipated after bringing their borrowing back in line with income growth. On the other hand, inflation could be slower due to the effects of the strong loonie, if household spending slows more than the central bank anticipates, or if the housing sector weakens suddenly.

On Tuesday,  Carney said left his benchmark rate at 1 percent and said further hikes “would need to be carefully considered,’’ repeating language he has used since last October when he paused his tightening campaign after three increases.