The Bank of Canada downgrades its outlook for economic growth in Canada, but leaves interest rates unchanged

The Bank of Canada left its key policy rate unchanged at 0.50% today. The Bank judges the current level of the overnight rate to be appropriate, but maintained a cautious tone in its outlook, acknowledging global risks and citing that the persistently low level of commodity prices has led to a modest downgrade to the bank's growth forecast.

Overall, the Bank's statement acknowledges the disappointment in global growth this year, but points out that in 2016 and 2017 the positive effects of cheaper energy and accommodative financial conditions should become increasingly evident. It characterizes Canada's economy as having rebounded, supported by the stimulative effects of past interest rate cuts and the past depreciation of the loonie. It also expects the U.S. economy to continue to grow at a solid pace

The Bank updated its forecasts in the accompanying Monetary Policy Report (MPR). Economic growth in Canada is expected to be better in Q3 than the Bank had estimated back in July. However, the Bank downgraded its real GDP growth forecasts to 2.0% in 2016 (previously 2.3%) and 2.5% in 2017(previously 2.6%). At the same time, as a result of the continued weakness expected in business investment, the Bank downgraded its estimate of the potential growth rate of Canada's economy. Therefore, the timing on when the Bank expects the economy to return to full capacity is only marginally later than was previously expected, at mid-2017.

For what it's worth, the Bank's forecast for core inflation was upgraded slightly over the forecast horizon, but it remains close to the Bank's 2% target. The Bank characterizes inflation as having evolved largely in line with the outlook in the July MPR. The Bank of Canada has recently de-emphasized its traditional core inflation measure, since it is being temporarily boosted by a weaker Canadian dollar. Thus, core inflation is currently out of step with where the Bank views "underlying inflation", or where inflation is running once temporary factors are stripped away. The bank estimates underlying inflation to be between 1.5-1.7%, consistent with recent speeches.

The Bank's decision to leave rates unchanged was widely expected. It maintained a cautious tone, acknowledging that the Canadian economy rebounded smartly from the contraction in the first half of the year, but that it continues to adjust to lower prices for oil and other commodities. The current level of monetary policy stimulus is necessary to facilitate this ongoing adjustment.

The downgrade to the Bank's growth outlook further out in the horizon is in line with more modest global growth and continued weakness in energy prices. This would typically mean the economy returning to full capacity at a later date, but the Bank also downgraded its estimate of Canada's pace of potential growth. As a result, there is little effect on the outlook for inflation.

At the same time, with the Bank now focused on a measure of underlying inflation rather than core, the performance of the economy relative to growth expectations is particularly important. The new forecasts in the MPR set the bar that Canada's economy must attain to see the eventual removal of monetary stimulus. If growth falls short of the mark, it could elicit further rate cuts.

"Overall, with the outlook for inflation little changed and the growth much the same as our latest outlook, we expect the bank to remain comfortably on the sidelines until the second half of 2017, when it is expected to embark on a modest pace of interest rate hikes", says TD Economics.