Monetary Policy Monitor
www.td.com/economics
HIGHLIGHTS
• The Bank of Canada will keep its
policy interest rate unchanged
at 1.00% next week and will
strike a cautiously optimistic
tone in the accompanying com-
muniqué.
• The release of the April MPR will
contrast a more robust outlook
for economic growth with a be-
nign backdrop for inflation. We
expect the steady absorption of
spare capacity will prompt the
Bank to move next in July and
take the overnight rate to 2.00%
by the end of 2011.
David Tulk
Chief Canada Macro Strategist
TD Securities
416-983-0445
TD Economics
April 8, 2011
BANK OF CANADA TO BIDE ITS TIME
TILL SUMMERTIME
Many central banks the world over are torn between the need to nurture still-
fragile economic recoveries and the fear of falling behind the curve to contain grow-
ing inflationary pressure. Not so for the Bank of Canada who is facing the enviable
combination of robust economic growth and remarkably benign inflation. While
the steady absorption of spare capacity will eventually necessitate the withdrawal of
monetary stimulus, there is no urgency to act next week. As a result, the overnight
rate will almost certainly be left unchanged at 1.00% on Tuesday. Meanwhile,
both the communiqué accompanying the decision and the Monetary Policy Report
(MPR) released the following day are expected to balance cautious optimism with
a laundry list of pre-
dominantly downside The Bank of Canada: How We See It
risks littering the road Inflation
ahead. Current Outlook
In contrast to the Hike Now
recent behaviour of
the market—which Event Risk USDCAD
had priced out hikes
until well into the sec-
ond half of the year April
following the tragedy May
in Japan and the rise July
of geopolitical ten- September US Economic
Financial Stability
sions in the Middle Growth
East and North Af- Each web corresponds to a Fixed Announcement Date where each variable
implies how many meeting dates away the variable is from a tightening in
rica—the tone taken policy. A move towards the origin corresponds to an earlier hike.
by the Bank next week
will likely solidify ex-
pectations for an earlier move. However, the Bank is not expected to be sufficiently
hawkish to set the stage for an increase in the overnight rate in May. Instead, we
reiterate our long-standing call for the next rate hike to occur in July and for a
year-end target of 2.00%.
Growth Outlook Premised on Putting America to Work
In the communiqué accompanying the March Fixed Announcement Date (FAD),
the Bank acknowledged that the recovery in Canada was proceeding faster than
they had forecast in the January MPR. The Bank also cited more evidence of a
rebalancing in the drivers of economic growth away from domestic demand and
towards net exports. These are encouraging developments, and they confirm our
suspicion that the forecast presented in the January MPR was too conservative in
its estimation of the impact that the fiscal stimulus in the United States announced
last December would have on the Canadian economy. Real GDP growth in 2010Q4
outstripped the Bank’s forecast by a full percentage point and the first quarter of
2011 is shaping up to do the same. Renewed strength in exports is a major con-
tributor to both quarters.

Canadian Real GDP Forecast (Annualized Percent Change)
Q1-11 Q2-11 Q3-11 Q4-11
TD 3.8 3.2 2.8 2.6
BoC 2.5 2.8 3.0 3.0
Consensus 3.3 3.1 3.0 2.9
Source: Bloomberg, Bank of Canada, TD Economics
Looking out over the balance of the year, the key to a
sustainable contribution from Canada’s export sector is a
recovery in the US labour market. Recall that at the March
FAD (where US activity was described as “solidifying” but
still supported by stimulus) the labour market had recently
disappointed the market by creating just 36K jobs in Janu-
ary while revealing a depressing set of benchmark revi-
sions. Since that time, the labour market appears to have
finally turned a corner, stringing together several months of
respectable job gains. With corporate profits auguring for
an accelerated pace of hiring, the Bank is likely to have a
greater confidence that the wider economic recovery will
be sustained in 2012.
The rebalancing in the drivers of Canadian economic
growth also implies a slower pace of domestic demand,
which will also support net exports through weaker imports.
Although the Bank conceded that consumer spending re-
mains quite robust, they expect a deceleration to a pace more
in line with income growth. While bank lending has begun
to moderate, the renewed strength observed in the labour
market will drive wage gains that in turn will support spend-
ing. When combined with the positive terms of trade shock
U.S. CORPORATE PROFITS AND EMPLOYMENT
Y/Y % Chg.
6 50
4 rates. However, the relative stability in the currency reduces
2 20
0 stronger US economy.
-2
Corporate Profit (Led 4 Quarters, RHS)
-4
Employment (LHS)
-6
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010
Source: Statistics Canada
Monetary Policy Monitor TD Economics
April 8, 2011 2
www.td.com/economics
provided by rising commodity prices, domestic demand may
not moderate as quickly as the Bank had initially thought.
2011 2012 Weaving together these various threads reveals a stron-
ger outlook for Canadian growth than what the Bank had
3.0 2.5 presented in the January MPR. While we expect a sizable
upwards revision to the near-term outlook for real GDP
2.4 2.8
growth, it remains an open question of how much activity
3.0 2.9
will be pulled forward from the future. If forecasted growth
in 2012 remains in the ballpark of the 2.8% forecast in Janu-
ary, the Bank is far more likely to embark on a sustained
sequence of rate hikes, which in our view, will begin in July.
Caveats to Growth are Both Transient and Persistent
There are two important caveats to the growth outlook.
The first is the disruption to the global supply chain caused
by the earthquake in Japan. The trading relationship between
the two countries is relatively small (Canadian exports and
imports to and from Japan represent 2.3% and 2.5% of their
respective totals) and firms will have the ability to meet
demand over the very short run by drawing down existing
inventories. It is very difficult to predict exactly how long
the supply disruption will last and already a shortage of
parts primarily in the auto industry have caused factories in
Canada to scale back production. It is expected that once
the electricity and transportation infrastructure in Japan is
restored, exports will rebound and the net impact will be a
redistribution of activity between quarters. From the per-
spective of the Bank, these developments will contribute
additional volatility to the quarterly profile for real GDP
growth, but is unlikely to impact the timing and magnitude
of rate hikes.
The second and far more persistent caveat to the growth
outlook is the currency. Since the Bank lifted its policy
rate off of the 25 basis point floor last June, the Canadian
dollar has consistently run ahead of what was incorporated
into each MPR by several cents. By providing an implicit
Y/Y % Chg. degree of tightening, the Canadian dollar takes some of the
pressure off of the Bank to aggressively normalize interest
40
30
the uncertainty facing exporters and makes it comparatively
easier to adapt to its strength when set against a cyclically
10
0
While the currency is forecast to remain well supported
-10
over the next two years, the risks are stacking up to the
-20
downside. In recent weeks, the Canadian dollar has mirrored
-30
the performance of equities and equity market volatility both
-40
of which are susceptible to global event risk and the targeted
end of QE2 looming at the end of June. At a minimum it
is expected that the Bank will cite the persistent strength
 Monetary Policy Monitor
April 8, 2011
CANADIAN DOLLAR VERSUS BANK OF CANADA
FORECAST
US$/C$
1.05
1.03
1.01
0.99 Jan MPR
0.97
Oct MPR
0.95 July MPR
0.93
Jul-10 Aug-10 Sep-10 Nov-10 Dec-10 Jan-11 Mar-11
Source: Bank of Canada, TD Securities
in the currency as a factor impeding growth next week but
when facing a terms of trade shock, the positive contribu-
tion to economic growth and income will dominate. But
as a warning to the market, any move to push the currency
higher in anticipation of hikes will prove to be self-defeating
as the Bank is just as likely to stand to the side and let the
currency slow economic growth and tame inflation.
Playing With Potential Growth to Cure Capacity
Constraints and Anchor Inflation
With the outlook for economic growth stronger than the
Bank had previously forecast, there is a risk that the output
gap could close a full year earlier than the end of 2012 cur-
rently expected. However, in the April MPR the Bank will
revisit its forecast for potential output and there is a definite
possibility that it could be revised higher (we outlined the
case in a recent research note available here). The net impact
of an upwards revision to both actual and potential output
will correspond to the closing of the output gap anywhere
from the middle to the end of 2012.
Although the output gap may close somewhat faster than
the Bank had initially previously forecast, the outlook for
inflation continues to unfold largely as outlined in the Janu-
ary MPR. Headline inflation does remain subject to higher
commodity prices (note the price of crude oil is nearly $20
higher today than in January) but for the moment wider
price pressures remain subdued. If anything, the weakness
observed in core inflation in February could introduce a very
modest downside risk to the Q1 forecast of 1.4%. It is this
overarching theme of a very benign backdrop for inflation
that provides the most compelling piece of evidence keep-
ing the Bank on the sidelines next week. Looking further
into the future, we expect that the downright anaemic 0.9%
TD Economics
3
www.td.com/economics
reading on core inflation observed in February will prove to
be the cyclical trough and that price pressures will gradu-
ally build in tandem with a dwindling overhang of excess
capacity.
Against a backdrop of a smaller cushion of disinflation-
ary slack, the prospect of higher inflation expectations will
present a challenge to the Bank. It is telling that in the
communiqué accompanying the last FAD, the reference that
inflation expectations were well anchored was dropped. At
that time, 10 year breakeven inflation had jumped by almost
10 basis points and has since moved higher by almost 25
basis points. In level terms, breakevens are currently in
the neighbourhood last observed in April 2010 when the
Bank abandoned its conditional commitment as a precursor
to lifting the overnight rate off of the 25 basis point floor.
This move was corroborated by the quarterly release of the
Business Outlook Survey (BOS) which noted that the pro-
portion of respondents expecting inflation rose to the upper
end of the 1-3% target range. The increase in commodity
prices largely drove this expectation higher, however, with
rapidly diminishing economic slack, we expect the Bank to
assume a less benign stance on the risk to future inflation.
The importance the Bank places on inflation expecta-
tions is well-known. In a recent speech, Governor Carney
linked the theme of what he described as a secular rise in
commodity prices to the conduct of monetary policy. In
particular Carney reiterated the view that “it is paramount
that monetary policy everywhere acts to ensure that infla-
tion expectations remain in line with medium-term policy
objectives”. In the context of the Canadian outlook, evi-
dence of rising inflation expectations will require that the
Bank remain vigilant and be prepared to act decisively in
the second half of the year.
10-YEAR CANADIAN BREAKEVEN INFLATION
Percent
2.6
2.5
2.4
2.3
2.2
April 2010
2.1 FAD
March FAD
2.0
1.9
1.8
Jan-10 Mar-10 May-10 Aug-10 Oct-10 Dec-10 Mar-11
Source: Bloomberg
 Monetary Policy Monitor TD Economics
April 8, 2011 4
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INFLATION MEASURES

CANADIAN CONSUMER PRICE INDEX (CPI) CANADIAN GROSS DOMESTIC PRODUCT (GDP)
Y/Y % Chg. AND PERSONAL CONSUMPTION DEFLATORS
4 4
CPI: All Items Y/Y % Chg.
6 6
3 3 Personal Consumption
4 Deflator 4
2 2
2 2
1 1
0 0
0 0
Midpoint of
Bank of Canada's -2 -2
-1 Bank of Canada -1
Target Band
Core CPI ex. 8 most volatile GDP Deflator
-2 items & indirect taxes -2
-4 -4
2006 2007 2008 2009 2010 1990 1994 1998 2002 2006 2010

Source: Statistics Canada/Haver Analytics Source: Statistics Canada/Haver Analytics

PRODUCT MARKET

CANADA'S OUTPUT GAP CANADIAN CAPACITY UTILIZATION RATE AND

Actual Real GDP Less Potential Real GDP UNFILLED ORDERS-TO-SHIPMENTS RATIO*
% % Ratio
3 88 1.0
2 Full Capacity Excess Demand
84 0.9
1
80 0.8
0 Capacity Utilization Rate (lhs)
-1 76 0.7
-2
72 0.6
-3
68 Unfilled Orders-to-Shipments 0.5
-4 Excess
Forecast Ratio (rhs)
-5 Supply 64 0.4
1992 1996 2000 2004 2008 2012 1993 1997 2001 2005 2009
Forecast by TD Economics as at March 2011 * Total industry excluding aerospace products and parts
Source: TD Economics, Statistics Canada, Bank of Canada Source: Statistics Canada/Haver Analytics

LABOUR MARKET

CANADIAN EMPLOYMENT AND UNEMPLOYMENT RATES SKILLED LABOUR SHORTAGE IN CANADA

Y/Y % Chg. % % of firms
5 13 70
Employment
4 (lhs) 12 60
3 11 50
2 10 40
1 9 30
0 8 20
-1 7 10
-2 Unemployment Rate 6 0
(rhs)
-3 5 2000 2002 2004 2006 2008 2010
1991 1994 1997 2000 2003 2006 2009 Source: Bank of Canada/Haver Analytics
Source: Statistics Canada/Haver Analytics
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April 8, 2011 5
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WAGES, COSTS AND REAL ESTATE

AVERAGE HOURLY EARNINGS OF PERMANENT EMPLOYEES CANADIAN UNIT LABOUR COSTS

Y/Y % Chg.
Y/Y % Chg.
5 8

6
4
4
3 2

0
2
-2
1 -4

-6
0
1990 1994 1998 2002 2006 2010
1998 2001 2004 2007 2010
Source: Statistics Canada/Haver Analytics
Source: Statistics Canada/Haver Analytics

BANK OF CANADA COMMODITY PRICE INDICES HOUSING PRICE INDICES

Y/Y % Chg. Y/Y % Chg.
60 60 25 25
Total
40 40 20 20
Resale
15 15
20 20
10 10
0 0 5 5
0 0
-20 -20
-5 -5
-40 Total excl. energy -40 New
-10 -10
-60 -60 -15 -15
1995 1998 2001 2004 2007 2010 1993 1997 2001 2005 2009

Source: Bank of Canada/Haver Analytics Source: CREA, Statistics Canada

INFLATION EXPECTATIONS

INFLATION EXPECTATIONS - CANADIAN FIRMS CANADIAN LONG-TERM GOVERNMENT BOND YIELD -

% CONVENTIONAL MINUS REAL RETURN
90
%
80 5
70
4
60
50 3
40
2
30
20 Per cent of firms expecting inflation to be above 3%
1
10 Per cent of firms expecting inflation to be 2-3%
0
0
1995 1998 2001 2004 2007 2010
2004 2005 2006 2007 2008 2009 2010 2011
Source: Bank of Canada Source: Bank of Canada
 Monetary Policy Monitor TD Economics
April 8, 2011 6
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