For starters, after trekking along from 2000-2007, the economy suffered a severe drop-off in 2008/09 which hasn't even come close to being re-couped.
Through June 2010, real GDP remains 4.9% below trend growth, which is up from the 6.6% gap as of June 2009.
And though the economy has turned up since troughing in May 2009, the continuation of that rebound isn't turning out to be as robust as the Bank had hoped and thought.
After growing at an annualized rate of 4.9% during the fourth quarter of 2009, the economy expanded 5.8% in the first quarter of this year, which trailed the Bank's forecast of 6.1%; and then growth decelerated in the second quarter to just 2%, lagging the Bank's forecast of 3%.
The Bank has now revised its growth forecasts down for each of the next five quarters, though it increased its forecasts for the five quarters after that. (This, by the way, is par for the course for the Bank ---- every time it revises its forecasts for growth in the near-term, it must, by the necessity of its mandate, revise its forecasts for later-term growth commensurately in the opposite direction. More on this later.)
Just for point of comparison, I think its worth noting how this forecasted growth, if it materializes as now expected, would compare to trend growth.
Though it does show how underwhelming this recovery has been and is projected to be, obviously trend growth from last decade doesn't hold much relevance as far as the Bank is concerned.
What the Bank is concerned with is how actual economic activity compares to what the Bank views as potential output. And growth of potential output these days is much lower than trend growth of the economy was for the last 5-10 years, because of a slowdown in the growth of the economy's rate of labour utilization, and, more particularly, of labour force productivity.
Canada entered the recession with the economy in a situation of excess demand (actual GDP above potential), but is now experiencing excess supply (actual GDP below potential).
As of July, the Bank believed that the output gap would be eliminated (actual GDP would converge on potential) by the end of 2011. Despite lowering its estimates for the growth of potential output (1.6% in 2010, 1.8% in 2011 and 2.0% in 2012), the Bank now forecasts that the output gap won't be eliminated until the end of 2012.
Here's why this is telling.
The Bank's job is to try to get CPI on target by the end of its forecast horizon, which in this case is to the end of 2012. It therefore needs to eliminate the output gap during that time period.
It previously had thought that it would have CPI on target by early 2012, by virtue of having eliminated the output gap by the end of 2011.
As of July, the Bank was forecasting that growth in 2012 would be 2% because (a) it believed that the output gap would be eliminated by then, (b) it wanted to keep CPI on target, and (c) it believes that the growth rate of potential output would be about 2% in 2012.
Therefore, to keep inflation on track, it would need to keep actual economic activity consistent with the economy's potential growth. Presumably, in order to do that, it would have needed to return to neutral monetary policy in 2011.
But by downgrading its views on economic growth for the last two quarters plus the next four quarters, the Bank is faced with the situation of having to engineer more growth nearer to the end of its forecast horizon in order to meet its objective.
In other words, because monetary policy works with a lag of at least 12 months, its economic growth forecasts for the next four quarters must be based in part on where it has its overnight rate set right now. So, despite remaining extraordinarily accomodative, the Bank doesn't think economic growth will be either (a) as strong as it had previously thought, or (b) strong enough to close the output gap.
Though year-over-year growth of 3.8% in 2010 followed by 2.7% in 2011, which were its forecasts as of the July MPR, would have done the job, growth of 3.0% this year (compared to 1.6% potential growth) followed by 2.4% next year (compared to 1.8% potential growth), which are its current forecasts, won't.
Therefore, the Bank will be required to enhance growth opportunities in 2012 in order to achieve the growth rate of 2.8% (compared to 2.0% potential growth) required to close the output gap.
Given that the Bank forecasts the output gap will not be closed until a year later than earlier projected, it seems safe to assume that the Bank will not return to neutral monetary policy until a year later than it earlier would have assumed.
As such, if its base case scenario had been that once it started hiking its overnight interest rate in July it would do so in sequential meetings until rates had been normalized, it seems that, based on currently available information, a resumption of that projected path of interest rates will likely wait a year.
Personally, given my expectations for deterioration in the U.S. economy (due to continued household deleveraging, continued reluctance on the part of banks to increase lending, fiscal spending headwinds rather than tailwinds, the end of the inventory bounce, spending cutbacks at the state and local levels, reluctance on the part of the business sector to make capital expenditure investments given its overcapacity, and no imminent rebound in the housing market or in the labour market), plus concerns about the unsustainability of household spending in Canada, as well as the prospect of global forces of competitive currency devaluation impairing Canadian trade balances, I am reluctant to believe that the Bank will be successful at closing the output gap over its forecast horizon.
In any case, on a breakeven basis, the current 2-year yield of 1.43% would be consistent with a time-path of overnight rates that involved the Bank staying on hold at 1% until October 2011, at which time rates would be hiked in four consecutive meetings to get to 2%.
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