MNI:BOC State of Play:Reasons For Caution Remain Despite CPI

By Yali N'Diaye

     OTTAWA (MNI) - News on the inflation front this week should be reassuring

for the Bank of Canada, showing perhaps the trough is behind.

     Yet reasons for caution remain, including the turn for the worse of NAFTA

talks and data confirming a slowdown in the third quarter, amid still elevated

household debt that should keep the central bank sensitive to the economy's

response to higher interest rates.

     Looking at hard data, the pace of inflation picked up to 1.6% in September,

Statistics Canada reported Friday, the third consecutive acceleration since the

low of 1.0% reached last June. As a result, inflation in the third quarter

averaged 1.4%, slightly more than the 1.3% projected by the central bank in

July, and a pick up from 1.3% in the second quarter.

     Importantly, the range for the three preferred measures of core inflation

continued to inch higher to 1.5%-1.8% in September, from 1.4%-1.8% in August,

1.3%-1.7% in July, and 1.2%-1.5% in June and May.

     Looking at the BOC's Business Outlook Survey published Monday, inflation

expectations strengthened, with 38% of firms expecting inflation to range

between 2% and 3% over the next two years, up from 24% in the spring survey and

the highest percentage since the fourth quarter 2012.

     Conversely, the percentage of firms expecting inflation to be at the bottom

end (1%-2%) of the BOC's 1%-3% target range dropped to 55% in the third quarter

from 70% in the second quarter, the lowest since the fourth quarter 2012 as

well.

     Yet the BOC did not overjoy, stating that despite moving up after remaining

stable for two years, inflation expectations "remain modest overall."

     The Bank added that despite an intensification of capacity and labor market

pressures - two factors high on its radar screen - over the past year,

"difficulties in meeting demand and reports of binding labor shortages are not

yet widespread."

     Besides, the central bank's scenario of a growth slowdown in the second

half of this year is materializing.

     Manufacturing sales in August beat expectations Wednesday as they rebounded

when analysts had anticipated further contraction, but the overall picture for

the sector remains that of a slowdown in the third quarter.

     Manufacturing sales rose 1.6% in August, less than offsetting July's 2.6%

drop. Volumes also rebounded 1.2%, but failed to offset July's 1.4% decrease.

     Earlier Friday, retail sales disappointed as they fell 0.3% in August on

widespread declines across 8 of 11 subsectors that were only partially offset by

gains in auto sales and gas station receipts, with overall sales volumes down

0.7%.

     Excluding motor vehicles and parts as well as gas stations, retail sales

contracted 1.3% on the month, the largest decline since December 2016.

     Then, there is what was the number one uncertainty in the July Monetary

Policy Report, and that is likely to be even more so in the October economic

update given the turn for the worse that NAFTA talks have taken on the back of

what Canada considers as "troubling" demands from the U.S.

     "The possibility of a notable shift toward protectionist global trade

policies remains a source of uncertainty surrounding the outlook," the BOC said

in its July MPR. In its September policy statement, it reiterated that

uncertainties around international trade remained significant.

     Governor Stephen Poloz reaffirmed in a September 27 speech the "many

external risks and uncertainties around our outlook, including geopolitical

developments and the rise of protectionist sentiment in some parts of the

world."

     When looking at Canada Mortgage and Housing Corporation's results of its

annual stress tests Wednesday, anti globalization and protectionism would even

have a stronger impact on the Canadian very open economy than a U.S.-style

housing crash would.

     Of four extreme scenarios used to stress test CMHC's mortgage loan

insurance and securitization businesses, one was "anti globalization," where a

negative global demand shock due to rapid U.S. interest rate increases and

China's unsustainable debt would lead to a downturn in both countries.

Protectionism would then arise, with "widespread use of tariffs and euro-zone

break-up."

     Under such scenario, the unemployment rate would soar to 15.3% and house

prices plunge 31.5% from peak to trough over the 2017-2022 period, more than the

peak unemployment rate of 12.0% and the housing price drop of 30.0% that a

U.S.-style house correction would trigger.

     While a breakdown of NAFTA talks is more of a credible concern for the BOC

than a break down of the EMU despite events in Catalonia, it would still be

enough to feed another wave of uncertainties that could slow the central bank's

tightening process.

     So overall, reasons for caution remain, and while inflation has picked up,

it is still far below the 2.0% target.

     That being said, the BOC surprised on June 12 with a much more hawkish

speech than priced in by markets, following through with a rate hike in July,

followed by weeks of silence and ultimately another surprise rate hike in

September.

     So October remains live. 

--MNI Ottawa Bureau; +1 613 869-0916; email: yali.ndiaye@marketnews.com

[TOPICS: M$C$$$]