No Hikes in Prime Rate until October: Bank of Nova Scotia

Posted on March 8, 2011

Paul Vieira, Financial Post · Monday, Mar. 7, 2011

OTTAWA — The improving economic backdrop has strengthened some economists’ view that the Bank of Canada will begin raising its benchmark rate in the second quarter – either in April or May – or at the very least in July, once the U.S. Federal Reserve is scheduled to end its US$600-billion asset purchase plan.

Not so the Bank of Nova Scotia. It is among the few research houses on Bay Street that believe the Bank of Canada, led by governor Mark Carney, will wait much longer – to October to be more precise. (Meanwhile, analysts at Capital Economics have reiterated their view the central bank remains on hold for all of 2011.) The main culprit: A weak U.S. dollar which could drive the loonie to US$1.08 by the end of the year.

Scotiabank economists Derek Holt and Gorica Djeric offered a detailed explanation of its view in a note to clients. Here is a summary of Scotiabank’s arguments:

• THE GREENBACK WILL KEEP SLIDING

Scotiabank is just plain bearish on the U.S. currency, as the Federal Reserve continues to pump cash into the system and keep its benchmark rate near zero. But the bank also believes there is a chance the White House further extends stimulus measures agreed upon late last year as opposed to allowing them expire – likely earning a rebuke from bond raters and fixed-income investors as Washington’s fiscal status would deteriorate further. That, in turn, would make the U.S. dollar even less favourable and likely adds to the loonie’s strength.

That could drive the loonie to as high as US1.08¢ by the end of 2011 — a full 12 cents above the most dovish view on the loonie, Scotia admits.

“This type of CAD strength imposes net tightening on the Canadian economy that we believe will do the Bank of Canada’s tightening for them. It is difficult to envision further Bank of Canada tightening when our expectation is that Canadian dollar will be lit up apart from what the Bank of Canada does.”

• GLOBAL UNCERTAINTY WILL CONTINUE

Turmoil in North Africa and the Middle East, and the impact that is having on energy prices, justifies the central bank keeping its powder dry for now. “No one has a clue as to how various geopolitical developments … will fully unfold,” Scotiabank said.

Also lurking in the background is Europe’s sovereign debt worries, and what policy makers will eventually agree to at a summit late this month.

• ECONOMIC SLACK REMAINS WIDE

Despite the better-than-expected fourth-quarter growth data, it likely didn’t have much of an impact on the country’s output gap that according to the last Bank of Canada estimate stood at 1.9% of the economy, Scotiabank said. It added it foresees risks to demand growth from government spending cuts, high commodity prices and new mortgage rules.

Furthermore, recent historical evidence would suggest there is a weak link between a narrowing output gap and inflationary pressure, especially since the Bank of Canada adopted an inflation-targeting regime about 20 years ago.

• TIGHTENING ALREADY UNDERWAY

There are developments underway which have the same impact as a rate hike, from a higher Canadian dollar; tougher mortgage financing rules which begin to take effect this month; the withdrawal of government stimulus; and, eventually, higher bond yields which will translate into higher rates on consumer loans.

• DOVISH FED

Fed chairman Ben Bernanke continues to signal a cautious, dovish approach, with expectations rate hikes begin some time next year. Raising rates in Canada now would just push an already strong loonie higher.

• INFLATION TARGETING REGIME

It is still not clear what the Bank of Canada’s inflation-targeting regime will look like once it is renewed at the end of the year. “Therefore, it's not clear to us if the Bank of Canada hikes the minute its operational core target gets to 2% in this cycle or is expected to do so,” Scotiabank said.

• FEDERAL & PROVINCIAL ELECTIONS

It remains unclear about whether the federal parties go on an election campaign this year once the federal budget is tabled on March 22. Still, Scotiabank said the central bank has raised rates only once during an election campaign in the last 20 years – in 2006, when the strong economy justified a hike – and will likely show caution again. Compounding matters are a series of provincial elections due in 2011, including Ontario where incumbent Premier Dalton McGuinty has repeatedly voiced concern about rate hikes and the upward push it provides to the Canadian dollar.

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