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Recession may be over but growth will be limited next year – CIBC

Inflation and interest rates will remain low as economy recovers

 The recession in Canada and the U.S. may be over, but the damage it left behind means Canadian growth and inflation will be muted next year, keeping Bank of Canada interest rate hikes on the sidelines until 2011, notes a new report from CIBC World Markets.

“While the 2009 recession may already be over, the slack it created is both large and likely to persist,” says CIBC’s Chief Economist Avery Shenfeld.  “Unlike the Bank of Canada, we don’t expect growth to average above the non-inflationary potential until 2011. But even under Governor Carney’s more optimistic trajectory, inflation will still be feeling the downward pressure of a sizeable output gap next year, one as large as we saw in the early 1980s and 1990s downturns.”

Mr. Shenfeld finds that while the core inflation rate did not decelerate as much as the Bank of Canada predicted earlier this year, there are reasons to expect a further easing in core inflation ahead. “A look at the underlying components for headline and core inflation helps identify what has, in our view temporarily, prevented core inflation from easing much thus far. And part of the answer lies in what economists call, the “income effect.”

He notes that by stripping out volatile items from the CPI, the Bank of Canada’s core measure now excludes most of the items that have been deflating, much more so than in the “old” core measure that simply left out all food and energy prices. With the “volatile” measures included, headline CPI is negative, largely driven by the dive in gasoline prices from a year ago. Lower gas prices have pulled down costs for intercity transportation fares as well, which the Bank of Canada also excludes from core inflation. Other non-core items such as natural gas, fuel oil and mortgage interest costs have also eased off.

“The deep dive in non-core items, has left those Canadians still working with some spending power,” adds Mr. Shenfeld. “While nominal wages have begun to decelerate in a slack labour market, a negative year-on-year inflation rate has meant that in real terms, the buying power of the average wage has escalated. So after filling their gas tank and paying their new, lower, mortgage bills, Canadians simply have more money in their pockets when they go shopping for other items, keeping those prices aloft.”

Mr. Shenfeld notes that economic slack usually takes time in exerting its disinflationary force. Given that wages get adjusted only as contracts come up and that some prices are fixed ahead of time (as is the case for catalogues), he believes the upward pressure on prices will ease in the coming months.

“Headline inflation rates won’t be as benign as they have been,” says Mr. Shenfeld. “If crude oil hugs the $60-70 range, energy will revert from a huge negative contributor to CPI to a modest positive in early 2010, with spillovers into related products like airline fares. But by reversing the “income effects” noted above, that implies diminished buying power for other goods, contributing to a cooling in core CPI. With a lag, a strong Canadian dollar will also provide a dampening impact on retail prices for imported goods and services.

“All told, Governor Carney will not fret about the stickiness of core inflation because, given time, core prices will come down. Look for headline and core prices to cross paths in the second quarter of 2010, at a level well under the Bank of Canada’s two per cent target. As a result, Canada’s inflation rate will be no threat to the Bank easily fulfilling its pledge to keep interest rates at a slim quarter point through mid-2010. In fact, market expectations for rate hikes in the first half of 2010 could be a full year too premature.”

Unlike the central bank’s outlook, the CIBC report does not see the Canadian economy gaining much benefit from a forecast U.S. recovery. It notes that the nature of the budding recovery will be very different than what we have seen in the past, with U.S. consumer spending taking a back seat to government stimulus.

CIBC’s analysis finds that protectionist trade barriers and a tilt in U.S. stimulus spending towards industries that have less-than-average propensities to import from Canada, will dampen the benefits that this country typically sees from economic growth south of the border.

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