Data show global recovery intact
The uncertainty created by Europe’s sovereign debt crisis caused ripples in financial markets in the past month but, outside the region, had little effect on the pace of economic growth. Data from Canada and the US confirmed that the recoveries are underway with Canada overshooting expectations while the U.S. economy posted solid growth. The emerging economies showed expected signs that momentum is slowing following a period of very rapid expansion. Eurozone data for April were a mixed bag with Germany showing strength but most other countries flagging, a worrying sign because the data pre-dates the implementation of fiscal restraint.
Uncertainty blurs rate outlook
Nervousness about the effect of the European debt crisis on the global economy has played out in varying degrees across multiple countries. The cost of capital, as measured by the LIBOR-OIS spread, edged higher in most countries; however, the increases have been much less than during the period of the sub-prime mortgage crisis and as such present a lower risk to the global financial system and economy. Central banks are now weighing domestic fundamentals against the likely effect of these external events on their economies. Both the Reserve Bank of Australia and Bank of Canada, which initiated a shift to reducing the level of policy accommodation, have adopted a meeting-by-meeting stance, and are monitoring both domestic and external economic developments. At the same time, the ECB, Bank of England and the Fed remained sidelined with the volatility in international markets layering on another reason to maintain the status quo on rates.
The newfound confidence from the Fed that the economy is firmly on a recovery track will not be enough to prompt a change in the policy rate given that the unemployment rate remains elevated, core inflation continues to fall and the uncertainty about the effect of Europe’s sovereign debt crisis on the world economy persists. In our view, it will take solid evidence that the labour market is continuing to grow and the unemployment rate is firmly on a downward trajectory before the Fed will rise the Funds target. We expect these conditions to be met by year end. In 2011, rate increases are likely to be a steady stream of 25 bps moves. The risk of a concerted shift in fiscal policy toward restraint will likely keep the Fed moving slowly on interest rates, so we reduced our end of 2011 target for the Fed Funds rate to 2.5% from 3.0%. With the European debt crisis putting debt and deficits on the front burner, the U.S. government may feel pressure to implement more stringent measures to cut back its spending overrun. Our base-case forecast incorporates an assumption that the cessation of stimulus measures will see the deficit-to-GDP ratio fall to 8.2% in fiscal year 2011 from 9.9%. This will buy the administration time to ensure that the recovery is firmly entrenched before taking further action to rein in the deficit.
Bank to proceed cautiously with rate increases
Recent data support our view that domestic economic conditions are strong enough that the ultra-low level of interest rates is no longer needed and that the economy can withstand a gradual rise in interest rates going forward. To that end, we expect the Bank will raise the policy rate in 25 bps increments to 1.5% by the end of this year. While we expect the tightening to continue in 2011, as the Bank works to bring the policy rate closer to neutral by the time Canada’s output gap is eliminated, we have revised down our end of 2011 target to 3.00% from 3.50%. Part of the rationale for this adjustment is that household debt and debt servicing are high and may weigh on consumer spending as interest rates move upward. Our forecast already assumes that balance sheet concerns will keep spending by households sub-par compared to past recoveries, and there is potential that our conservative forecast for personal income will prove too low. However, against a backdrop of a slow moving Fed and risks emanating from the household sector, the Bank is likely to remain cautious and maintain a sub-neutral policy rate until 2012.
RBC Economics Research - ©Royal Bank of Canada.
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