Wednesday, August 09, 2006

Bank of Canada should lead move to lower interest rates: study


Globe and Mail Update

The North American debate is on over whether it will be the U.S. Federal Reserve Board or the Bank of Canada that leads the move to lower rates early next year as the two economies slow and inflation pressures diminish.

And a recent study by CIBC World Markets Inc. concludes that a drop in domestic retail prices will give the upper hand to the Bank of Canada.

It is only one day since the Fed indicated that it planned to hold the federal funds rate steady at 5.25 per cent after 17 consecutive one-quarter of a percentage point hikes, but already there has been speculation it will have to begin reducing rates early next year.

The strength of the loonie as well as the lower inflation rates in Canada "will continue to allow the Bank of Canada to steer a lower course on interest rates," CIBC World Markets concluded.

Some strategists expect the U.S. economy will slow more than the resource-based Canadian economy and that the Bank of Canada will be less willing to lower rates because of capacity constraints.

However, Avery Shenfeld, the managing director and senior economist of the CIBC World Markets said today that the "Bank of Canada could outgun the U.S. Fed in interest rate cuts in 2007."

Canada's inflation rate is nearly 2 per cent below the U.S. and that cushion should remain as the appreciation of the loonie begins to show up in lower retail prices, he said. It takes up to two-years for the buying power of the loonie to translate into savings on the retail shelves, Mr. Shenfeld said. "But competition, including that from on-line or cross-border outlets, eventually sees the Canadian dollar's appreciation show up in cooler inflation than in the U.S.," he said.

The study found that a 10 per cent appreciation in the loonie lowers Canada's goods price inflation by one-half of a percentage point compared with the U.S. in two years time.

Canada's target overnight bank rate stands at 4.25 per cent, a full percentage point below the regulated rate in the United States. The Bank of Canada stopped raising rates on May 24.

Today, the yield on two-year U.S. Treasuries was 4.91 per cent, compared with 4.12 per cent on the two-year Canadian government bond.

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