The Canadian economy is operating just above its production capacity, according to the October Monetary Policy Report released today by the Bank of Canada.

While global economic growth is expected to be a little higher than previously anticipated, a weaker near-term outlook for the U.S. economy has curbed the near-term prospects for Canadian exports and growth, the bank said.

The Bank’s outlook for growth in the Canadian economy has been revised down slightly from that outlined in July’s Monetary Policy Report Update.

The Bank’s base-case projection now calls for average annual GDP growth of 2.8% in 2006, 2.5% in 2007, and a return to 2.8% in 2008. Weakness in labour productivity growth has led the Bank to lower its assumption for potential growth to 2.8% for the 2006-08 period. Together, these factors imply that the small amount of excess demand now in the economy will be eliminated by mid-2007.

Core inflation is expected to move a bit above 2% in the coming months but return to the 2% target by the middle of 2007 and remain there through 2008. Lower energy prices have led to a downward revision to the near-term projection for total CPI inflation. Total inflation (which includes the temporary impact of the GST reduction) will likely average about 1.5% through the second quarter of 2007, before returning to the 2% target and remaining there through to the end of 2008.

As the Bank noted at the time of its September 5 interest rate announcement, the risks around the base-case projection are judged to be a little greater than at the time of the July Update. The main upside risk relates to the momentum in household spending and housing prices, while the main downside risk is that the U.S. economy could slow more sharply than expected, leading to lower Canadian exports. The Bank judges that the risks to its inflation projection are roughly balanced.

On October 17, the Bank left its key policy rate unchanged at 4.25%.

Today’s report reaffirmed economists’ views that the Bank remains on the sidelines for the time being.

RBC Financial Group notes that the Bank of Canada cut its growth forecast and adjusted its potential GDP estimate. The core inflation forecast was also boosted in near-term, but the medium-term outlook remains unchanged.

“The Bank pared back forecasts for GDP growth in 2006 and 2007 reflecting a revision to its forecast for net exports. Although the medium-term outlook for inflation is unchanged with both the all-items and core rates forecast to gravitate to 2% by the middle of 2007, the near-term forecast for the core rate has been increased,” RBC notes. “The core inflation rate is expected to average 2.1% in the fourth quarter of 2006, compared to the July forecast of 2% and 2.2% in the first half of 2007 (from 2%).”

“The combination of slower growth but a near-term pick up in core inflation bodes for the Bank to keep the policy rate steady as policy-makers watch to see if the weaker pace of growth leads to a decline in underlying price pressures as they expect,” RBC adds. “We continue to forecast that the Bank will hold the overnight rate at 4.25% until late 2007 when we expect a 25 basis point rate cut.”

TD Bank says that, from an economist’s perspective, the highlight of the report was a downward revision to the economy’s potential growth rate to 2.8% through 2008 owing to a weaker outlook for labour productivity.

“The combination of the revisions to both potential and actual economic growth paint a picture of the Canadian economy that is very similar to that described in the previous MPR in two significant ways: For one, despite slower economic growth, the economy is expected to remain very close to its productive capacity. And second, with an economy remaining close to capacity, inflation is forecast to remain very close to target through 2008. As a result, the Bank appears to be signaling no change in monetary policy over the near term,” it says.

“In a broader sense, the adjustment to potential output reflects the inherent difficulty of conducting monetary policy when the economy is operating close to its potential growth rate and inflation is running virtually at the target rate. If a change in rates is not imminent, the Bank is handcuffed to present a forecast where the economy continues to remain at capacity with inflation on target,” TD observes. “In this context, the actual forecast becomes less important while the risks to the baseline forecast take on considerably more weight.”

@page_break@RBC says that, “once again the Bank outlined upside risks emanating from the momentum in household spending and housing prices and balanced that against downside risks coming from a ‘sharper slowdown in the housing sector in the United States’ and concluded that these risks are ‘roughly balanced’.”

The view of TD Economics is that while the downside risks are likely to remain, the upside risk posed by Canadian consumers and housing will begin to subside. “As a result, our forecast for real GDP is weaker than that of the Bank over the next four quarters. This in turn leads us to believe that the Bank will take out a modest insurance policy of 50 basis points of cuts over the first half of 2007,” it says.

BMO Nesbitt Burns says that, “this near-term upside risk for inflation and medium-term downside risk for growth leaves the Bank firmly — albeit nervously — glued to the sidelines.”

“There are no major shifts in tone from Tuesday’s statement, although the Bank’s renewed concerns about medium-term downside risks hint at where their underlying bias may really lie. Still, at the same time, the Bank does sound more anxious over the inflation outlook, due to housing, wages, consumer credit growth and the Alberta boom,” it says. “This mixed message is just another reason to believe the Bank will fully maintain its strict neutrality even as the Fed still talks hawkish. The major conclusion is that current interest rates are “consistent” with achieving the 2% inflation target.”