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Monetary Policy ReportJuly 2012

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The Monetary Policy Report is available on the Bank of Canadas website at banko canada.ca .

For further information, contact:

Public InformationCommunications DepartmentBank of Canada234 Wellington StreetOttawa, Ontario K1A 0G9

Telephone: 613 782-8111 ;1 800 303-1282 (toll ree in North America)Email: in o@banko canada.ca ; Website: banko canada.ca

ISSN 1201-8783 (Print)ISSN 1490-1234 (Online)2012 Bank of Canada

Canadas Ination-Control Strategy 1

Infation targeting and the economy The Banks mandate is to conduct monetary policy to pro-

mote the economic and nancial well-being o Canadians

Canadas experience with in ation targeting since 1991has shown that the best way to oster con dence in thevalue o money and to contribute to sustained economicgrowth, employment gains and improved living standardsis by keeping in ation low, stable and predictable

In 2011, the Government and the Bank o Canada renewedCanadas in ation-control target or a urther ve-yearperiod, ending 31 December 2016 The target, as measuredby the total consumer price index (CPI), remains at the2 per cent midpoint o the control range o 1 to 3 per cent

The monetary policy instrument

The Bank carries out monetary policy through changesin the target overnight rate o interest 2 These changesare transmitted to the economy through their in uenceon market interest rates, domestic asset prices and theexchange rate, which a ect total demand or Canadiangoods and services The balance between this demandand the economys production capacity is, over time, theprimary determinant o in ation pressures in the economy

Monetary policy actions take timeusually rom six toeight quartersto work their way through the economyand have their ull e ect on in ation For this reason,monetary policy must be orward looking

Consistent with its commitment to clear, transparentcommunications, the Bank regularly reports its perspec-tive on the orces at work on the economy and their

implications or in ation The Monetary Policy Report is akey element o this approach Policy decisions are typi-cally announced on eight pre-set days during the year,and ull updates o the Banks outlook, including risks tothe projection, are published our times per year in theMonetary Policy Report

Infation targeting is symmetric and exible Canadas in ation-targeting approach is symmetric , which

means that the Bank is equally concerned about in ationrising above or alling below the 2 per cent target

Canadas in ation-targeting ramework is exibleTypically, the Bank seeks to return in ation to target overa horizon o six to eight quarters However, the mostappropriate horizon or returning in ation to target willvary depending on the nature and persistence o the

shocks bu eting the economy

Monitoring infation In the short run, a good deal o movement in the CPI is

caused by uctuations in the prices o certain volatilecomponents (e g , ruit and gasoline) and by changes inindirect taxes For this reason, the Bank also monitors aset o core in ation measures, most importantly theCPIX, which strips out eight o the most volatile CPI com-ponents and the e ect o indirect taxes on the remainingcomponents These core measures allow the Bank tolook through temporary price movements and ocus on

the underlying trend o in ation In this sense, core in a-tion is monitored as an operational guide to help the Bankachieve the total CPI in ation target It is not a replace-ment or it

1 See Joint Statement of the Government of Canada and the Bank of Canada on the Renewal of the Ination-Control Target (8 November 2011) andRenewal of the Ination-Control Target: Background InformationNovember 2011 , which are both available on the Banks website

2 When interest rates are at the zero lower bound, additional monetary easing to achieve the in ation target can be provided through three unconven-tional instruments: (i) a conditional statement on the uture path o the policy rate; (ii) quantitative easing; and (iii) credit easing These instrumentsand the principles guiding their use are described in the Annex to the April 2009 Monetary Policy Report

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Mo r Po c R porJuly 2012

This is a report o the Governing Council o the Bank o Canada:Mark Carney, Ti Macklem, John Murray, Timothy Lane, Jean Boivin and Agathe Ct.

This report includes data received up to 13 July 2012.

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Despite the troubles abroad, there has been a quiet pride in howCanada has ared....And a very strong desire to move orward.

Mark Carney

Governor, Bank o Canada1 May 2012Toronto, Ontario

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CoOverview 1

Global Economy 3

Global Financial Conditions 4

Euro Area 5

United States 7

Japan 10

Emerging-Market Economies 10Box 1:Recent Developments in Emerging-Market Economies 12

Commodity Prices 13

Implications or the Canadian Economy 15

Canadian Dollar 16Box 2: Improving the Bank o Canada Commodity Price Index 17

Canadian Economy 19Financial Conditions 19

Estimated Pressures on Capacity 22

The Real Economy 24Box 3: Canadas Share o the Global Export Market 31

In ation 32

Risks to the Outlook 35

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O rGlobal growth prospects have weakened since April. While the economicexpansion in the United States continues at a gradual but somewhat slowerpace, developments in Europe point to a renewed contraction. In China andother emerging economies, the deceleration in growth has been greaterthan anticipated, re ecting past policy tightening and weaker externaldemand. This slowdown in global activity has led to a sizable reductionin commodity prices, although they remain elevated. The combination oincreasing global excess capacity over the projection horizon and reducedcommodity prices is expected to moderate global in ationary pressures.Global fnancial conditions have also deteriorated since April, with periodso considerable volatility. The Banks base-case projection assumes that theEuropean crisis will continue to be contained, although this assumption issubject to downside risks.

While global headwinds are restraining Canadian economic activity,domestic actors are expected to support moderate growth in Canada. TheBank expects the economy to grow at a pace roughly in line with its produc-tion potential in the near term, be ore picking up through 2013. Consumption

and business investment are expected to be the primary drivers o growth,re ecting very stimulative domestic fnancial conditions. However, their pacewill be in uenced by external headwinds, notably the e ects o lower com-modity prices on Canadian incomes and wealth, as well as by record-highhousehold debt. Housing activity is expected to slow rom record levels.Government spending is not projected to contribute to growth in 2012 andto contribute only modestly therea ter, in line with plans to consolidatespending by ederal and provincial governments. Canadian exports areprojected to remain below their pre-recession peak until the beginning o2014, re ecting the dynamics o oreign demand and ongoing competitive-ness challenges, including the persistent strength o the Canadian dollar.

The Bank projects that the economy will grow by 2.1 per cent in 2012,

2.3 per cent in 2013 and 2.5 per cent in 2014. The economy is expected toreach ull capacity in the second hal o 2013, thus operating with a smallamount o slack or somewhat longer than previously anticipated.

Core in ation is orecast to remain around 2 per cent over the projectionhorizon as the economy operates near its production potential, growth inlabour compensation stays moderate and in ation expectations remain wellanchored. Given the recent drop in gasoline prices and with utures pricessuggesting persistently lower oil prices, the Bank expects total CPI in ationto remain noticeably below the 2 per cent target over the coming year be orereturning to target around mid-2013.

1 OveRview BANK OF CANADA Monetary Policy rePort July 2012

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The in ation outlook in Canada is subject to signifcant risks.

The three main upside risks to in ation in Canada relate to the possibility ohigher global in ationary pressures, stronger Canadian exports and strongermomentum in Canadian household spending.

The three main downside risks to in ation in Canada relate to the Europeancrisis, weaker global momentum and the possibility that growth in Canadianhousehold spending could be weaker.

Overall, the Bank judges that the risks to the in ation outlook in Canada areroughly balanced over the projection period.

Re ecting all o these actors, on 17 July, the Bank decided to maintain thetarget or the overnight rate at 1 per cent. To the extent that the economicexpansion continues and the current excess supply in the economy is grad-ually absorbed, some modest withdrawal o the present considerable monetarypolicy stimulus may become appropriate, consistent with achieving the2 per cent in ation target over the medium term. The timing and degree oany such withdrawal will be weighed care ully against domestic and global

economic developments.

2 OveRview BANK OF CANADA Monetary Policy rePort July 2012

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G o eco omThe prospects or global economic growth have weakened since the AprilMonetary Policy Report . While the economic expansion in the United Statescontinues at a gradual but somewhat slower pace, developments in the euroarea point to a renewed contraction. In China and other emerging-marketcountries, the deceleration in economic growth has been greater than pre-viously anticipated. This slowdown in global economic activity has led to asizable reduction in commodity prices, although they remain elevated.Global fnancial conditions have deteriorated since the last Report , withperiods o considerable volatility.

Global economic growth is expected to moderate rom 3.8 per cent in 2011 to3.1 per cent in 2012 and 2013, be ore rising to 3.5 per cent in 2014 ( Table 1 ).Given this relatively modest growth profle, global excess capacity is expectedto increase over the projection horizon. The Banks base-case scenarioassumes that the crisis in the euro area will continue to be contained,although this assumption is subject to downside risks. The projection alsoassumes that current legislation in the United States, which implies a severetightening o fscal policy at the beginning o 2013 (the so-called fscal cli ),

will be modifed to spread the fscal contraction over several years.

Underlying in ation pressures in advanced economies are expected to easeover the projection horizon in response to the considerable excess capacity.

As a result, central banks in some advanced economies have provided addi-tional monetary stimulus, either by lowering policy interest rates ( Chart 1 )or by undertaking urther unconventional measures. In emerging-marketeconomies (EMEs), some o the past monetary tightening is being reversedand new fscal stimulus has been announced.

The prospects or global economic growth have weakened

Global excess capacity isexpected to increase

Table 1: Projection or global economic growth

Share of real globalGDP a (per cent)

Projected growth b (per cent)

2011 2012 2013 2014

United States 19 1.7 (1.7) 1.9 (2.3) 2.1 (2.5) 3.0 (3.6)

Euro area 14 1.5 (1.5) -0.6 (-0.6) 0.3 (0.8) 1.3 (1.4)

Japan 6 -0.7 (-0.7) 2.5 (1.9) 1.3 (1.6) 0.9 (1.6)

China 14 9.3 (9.2) 7.8 (8.1) 7.8 (8.0) 7.8 (8.0)

Rest of the world 47 4.3 (4.3) 3.2 (3.4) 3.2 (3.5) 3.3 (3.7)

World 100 3.8 (3.8) 3.1 (3.2) 3.1 (3.4) 3.5 (3.8)

a. GDP shares are based on International Monetary Fund (IMF) estimates o the purchasing-power-parity(PPP) valuation o country GDPs or 2011. Source: IMF, World Economic Outlook , April 2012b. Numbers in parentheses are projections used or the April 2012 Monetary Policy Report .Source: Bank o Canada

3 GlObal eCOnOMy BANK OF CANADA Monetary Policy rePort July 2012

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Global Financial ConditionsGlobal fnancial conditions have deteriorated since the last Report .Re newed worries about the sustainability o sovereign debt and the healtho the banking sectors in some euro-area economies, as well as downwardrevisions to the prospects or global economic growth, have led to a signif-

cant deterioration in market sentiment. Spreads on some euro-area sover-eign bonds have risen markedly over the period, with Spanish spreadsrelative to German bonds reaching euro-era record highs ( Chart 2 ).

At the same time, growing investor appetite or sa er and more-liquid assetshas pushed government bond yields in most major advanced economiesto record lows ( Chart 3 ) and exerted strong upward pressure on currenciessuch as the U.S. dollar and the Japanese yen. The value o the euro, in con-trast, has weakened noticeably and a large number o emerging-market cur-rencies have also allen, in response to an abrupt reversal o capital ows.

Other asset classes have also been a ected by changes in market senti-ment. Equity prices have so tened in the past ew months, especially bankequities ( Chart 4 ). However, corporate bond issuance outside o Europe hasheld up relatively well and spreads are little changed rom their levels at thetime o the last Report .

Bank unding conditions have tightened in recent months, although theextent has varied across countries. Banks in a number o economies, suchas the United States and the United Kingdom, have experienced a rela-tively modest rise in unding costs, while banks in the euro area are acingincreased pressures. As a consequence, euro-area banks have continued totighten credit conditions ( Chart 5 ).

Developments in Europe have also a ected bank lending conditions in anumber o other countries. Banks in the United Kingdom have tightenedlending terms on some loans to households and corporations. Although

Global nancial conditions have deteriorated

Corporate bond issuanceoutside o Europe has held up

Note: On 5 October 2010, the Bank o Japan changed the target or its policy rate rom 0.1 per cent to arange o 0.0 to 0.1 per cent. The U.S. Federal Reserve has been maintaining a target range or its policyrate o 0.0 to 0.25 per cent since 16 December 2008.Sources: Bank o Canada, U.S. Federal Reserve,European Central Bank and Bank o Japan Last observation: 13 July 2012

Canada United States Euro area Japan

2008 2009 2010 2011 20120.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

%

Chart 1: Policy interest rates are at historically low levels in advancedeconomiesPolicy interest rates, daily data


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U.S. banks have implemented a modest easing o lending standards morebroadly in recent months, they have tightened standards on loans toEuropean banks and to non-fnancial frms that have substantial exposureto Europe.

Euro AreaReal GDP in the euro area contracted by 1.3 per cent in the ourth quarter o2011 and was basically unchanged in the frst quarter o 2012. While GDPgrowth was stronger in the frst quarter than anticipated in the April Report ,this positive surprise is unlikely to persist, as economic conditions continueto deteriorate in many euro-area countries. With nearly hal o all euro-area

U.S. banks have implemented a modest easing o lending standards

Economic conditionscontinue to deteriorate in

many euro-area countries

Note: Owing to data limitations, yields on 9-year sovereign bonds are used or Ireland.Source: Bloomberg Last observation: 13 July 2012

Ireland (le t scale) France Italy Spain

2009 2010 2011 20120

100

200

300

400

500

600

700

Basis pointsBasis points

0

200

400

600

800

1000

1200

1400

Chart 2: Yield spreads on Italian and Spanish sovereign bonds are at ornear all-time highs10-year sovereign yield spreads over German bonds, daily data

April Report

Source: Bloomberg Last observation: 13 July 2012

Canada United States Germany Japan United Kingdom

2009 2010 2011 20120.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

%

Chart 3: Government bond yields in most major advanced economies haverecently hit new lowsYields on 10-year sovereign bonds, daily data

April Report


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economies already in recession, real GDP and private domestic demand arebelow their pre-crisis peaks by about 2 per cent and 6 per cent, respect-ively. The adverse eedback loop between weakening economic activity andsovereign and banking sector vulnerabilities has intensifed, rendering thetask o fscal consolidation even more challenging. Moreover, the worseningeconomic situation in the peripheral economies has begun to spread to thepreviously resilient core countries. Sentiment has deteriorated and, in June,purchasing managers indexes were generally at a level consistent with acontraction in economic activity, even in the core economies.

Euro-area GDP is projected to contract in the fnal three quarters o 2012( Chart 6 ). A very modest recovery is expected to begin in 2013, driven largelyby a strengthening in exports supported by the low level o the euro and a

Euro-area GDP is projected to contract in the nal three quarters o 2012


Canada United States Euro area United Kingdom Emerging markets

2011 2012Jan Apr Jul Oct Jan Apr Jul

65

70

75

80

85

90

95

100

105

110

115

Index

Chart 4: Equity prices have decreased in the past ew monthsIndexes (1 January 2011 = 100), daily data

April Report

Note: Data re ect responses to the euro-area Bank Lending Survey.

Source: European Central Bank Last observation: 2012Q1

-10

0

10

20

30

40

50

2010 2011 2012 2010 2011 2012 2010 2011 2012 2010 2011 2012 2010 2011 2012

%

Tightening in credit standards

Factors contributing to credit tightening

Costs relatedto bankscapitalpositions

Tightening

Easing

Accessto marketfnancing

Banksliquiditypositions

Expectationsregardinggeneraleconomicactivity

Chart 5: Banks in the euro area have continued to tighten lending conditionsNet percentages o banks contributing to credit tightening or businesses


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gradual pickup in external demand. Domestic demand is orecast to act as adrag on growth in 2013 and to expand only modestly in 2014, in response to aslight improvement in confdence and some easing in fnancial conditions.Relative to the April Report , growth prospects in the euro area are weakerover the entire projection horizon, owing to more restrictive fnancial condi-tions, additional fscal austerity measures and lower confdence. 1

Despite subdued economic conditions, headline in ation in the euro area,at 2.4 per cent in June, has remained relatively elevated, partly re ectingincreases in indirect taxes and administered prices. Underlying in ationpressures are expected to moderate over the projection horizon, owingto the impact o growing unused capacity and projected declines in com-modity prices, although measured in ation will be held up somewhat by thee ects o additional increases in indirect taxes and administered prices.

European policy-makers announced a number o new initiatives on 29 Junedesigned to rein orce the monetary union and ease borrowing conditions orsovereigns. 2 Timely implementation o these signifcant measures, together withother substantive re orms, will likely be needed to continue to contain the crisis.

United StatesThe U.S. economic expansion is continuing at a modest pace, with real GDPgrowing by 1.9 per cent in the frst quarter o 2012, slightly weaker thanexpected at the time o the April Report . The profle or U.S. economicgrowth has been revised downward over the projection horizon, re ecting a

1 The downward revision to the outlook or growth in 2012 is masked by the positive surprise to GDP inthe frst quarter, as growth on an average annual basis is unchanged rom the last Report.

2 See the 29 June Euro Area Summit Statement, available at < http://consilium.europa.eu/uedocs/ cms_data/docs/pressdata/en/ec/131359.pd >.

The U.S. economic expansion is continuing at a modest pace

Note: The Big Five modern fnancial crises, as described in Reinhart and Rogo (2008), are Spain (1977),Norway (1987), Finland (1991), Sweden (1991) and Japan (1992). See C.M. Reinhart and K.S. Rogo ,Is the 2007 U.S. Sub-Prime Financial Crisis So Di erent? An International Historical Comparison,

American Economic Review: Papers and Proceedings 98, no. 2 (2008): 33944.Sources: Eurostat, Organisation or Economic Co-operation and Development,and Bank o Canada projections

90

95

100

105

110

115

120

-2 -1 0 1 2 3 4 5 6

IndexIndex

Start o the recession

Years be orethe start othe recession

Years a terthe start othe recession

Euro-area current cycle

Base-case projection

The Big Five modern fnancial crises

Range o past euro-area recessions(1980 onward)

Chart 6: Europe is stagnatingEuro-area real GDP across economic cycles; start o recession = 100, quarterly data


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more gradual improvement in labour market conditions, weaker externaldemand and the recent rise in the U.S. dollar. These in uences are expectedto more than o set the positive impact rom the easing in U.S. monetarypolicy and lower oil prices.

U.S. real GDP is orecast to grow by slightly less than 2 per cent, on average,

through the frst hal o 2013, in response to the restraining e ects rom fscalconsolidation, household deleveraging, modest growth in external demandand tight fnancial conditions ( Chart 7 ). Economic growth is expected tostrengthen therea ter, owing in part to a modest pickup in external demand.

Fiscal consolidation is expected to have a signifcant dampening e ect onU.S. economic growth over the projection horizon. In view o the considerableuncertainty regarding the pace o fscal consolidation, the Banks base-casescenario assumes that the fscal drag will amount to roughly 1 percentagepoint in 2012 and 1.5 percentage points in 2013 and 2014 ( Chart 8 ). However,a severe tightening o fscal policy at the beginning o 2013 (the fscal cli ) isbuilt into current legislation, which could reduce U.S. real GDP growth nextyear by up to 4 percentage points i it is not amended.

In contrast, monetary policy is expected to remain highly accommodativethroughout the projection horizon. The U.S. Federal Reserve has recentlylengthened the duration o its program to extend the average maturity o itsholdings o securities rom June 2012 to the end o the year and continuesto expect that economic conditions are likely to warrant exceptionally lowlevels or the ederal unds rate, at least through late 2014.

Growth in consumption is expected to remain modest over the projectionhorizon as households continue to rebuild their balance sheets in an environ-ment o subdued labour market conditions, fscal restraint and persistentlyweak house prices ( Chart 9 ). The boost to real purchasing power rom loweroil prices should provide some support to household spending, however.

Fiscal consolidation is expected to have a signi cant dampeninge ect on U.S. economic growth

Note: The Big Five modern fnancial crises, as described in Reinhart and Rogo (2008), are Spain (1977),Norway (1987), Finland (1991), Sweden (1991) and Japan (1992). See C.M. Reinhart and K.S. Rogo ,Is the 2007 U.S. Sub-Prime Financial Crisis So Di erent? An International Historical Comparison,

American Economic Review: Papers and Proceedings 98, no. 2 (2008): 33944.

Sources: U.S. Bureau o Economic Analysis, Organisation or Economic Co-operation and Development,and Bank o Canada projections

85

90

95

100

105

110

115

120

125

130

135

140

-2 -1 0 1 2 3 4 5 6 7

Index

Start o the recession

Years be orethe start othe recession

Years a terthe start othe recession

U.S. current cycleBase-case projection

The Big Five modern fnancial crisesRange o past U.S. recessions (1948 onward)

Chart 7: U.S. real GDP growth is projected to remain relatively modestcompared with previous U.S. recoveriesU.S. real GDP across economic cycles; start o recession = 100, quarterly data


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The U.S. housing market continues to be weak relative to previous recov-eries. The demand or housing remains subdued in light o the tight under-writing standards or new mortgage origination, while the large overhango unoccupied dwellings and homes in the oreclosure pipeline continuesto restrain increases in both home-building and prices. Housing startshave picked up to above 700,000 units rom a recessionary trough near500,000 units, but remain well below the 1.7 million-unit average in thedecade leading up to the crisis. Residential construction is expected topick up urther rom these still-low levels, supported by an improvement inlabour market conditions, a gradual easing in lending conditions and areduction in the stock o vacant homes.

The U.S. housing market continues to be weak

Note: The contribution o fscal policy to growth includes both direct government expenditures and theindirect e ects on other components o aggregate demand.

Sources: U.S. Bureau o Economic Analysis and Bank o Canada calculations and projections

-2

-1

0

1

2

3

4

5

2011 2012 2013 2014

%

GDP growth excludingfscal policy

Estimated contribution rom fscal policy GDP growth

Chart 8: Fiscal consolidation is projected to have a signi cant dampeninge ect on U.S. economic growth through 2014

Annual data

Note: Shaded areas represent U.S. recessions. Sources: U.S. Bureau o Labor Statistics and Statistics Canada Last observation: June 2012

Canada United States

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 201257

58

59

60

61

62

63

64

65

%

Chart 9: Subdued labour market conditions in the United States are expectedto restrain the growth o consumptionRatio o employment to population, monthly data


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Elevated vacancy rates and tight borrowing conditions are also restraininggrowth in non-residential construction. A modest recovery is projected toun old in this sector beginning in 2013, as the e ects rom these actorsgradually dissipate.

Growth in business investment in 2012 is projected to be somewhat con-

strained by uncertainty stemming rom the fscal debate in the United Statesand by the weaker global economy. Together with exports, business investmentis nonetheless expected to continue to provide signifcant support to the U.S.economic expansion over the projection horizon. As the situation in Europeimproves and the uncertainty regarding U.S. fscal policy is resolved, businessinvestment is projected to gain momentum, supported by strong corporatebalance sheets and profts. Although growth in U.S. exports is expected todecelerate during 2012, owing to the impact o slowing demand rom tradingpartners and the past appreciation o the U.S. real e ective exchange rate, it isprojected to strengthen starting in 2013 when global demand begins to recover.

In light o the subdued pace o the U.S. economic expansion, the amounto excess supply in the economy is expected to remain signifcant through

2014 and is projected to dampen underlying in ation pressures.

JapanReal GDP in Japan rose by 4.7 per cent in the frst quarter o the year, sig-nifcantly above expectations at the time o the April Report . The reboundin GDP growth re ects a marked increase in consumption supported bysubsidies or the purchase o uel-e fcient motor vehicles, and a robust risein public spending related to reconstruction. Exports also grew strongly,buttressed by urther recovery rom the impact o ooding in Thailand. Within ation remaining well below the o fcial goal o 1 per cent, the Bank oJapan decided to expand the size o its Asset Purchase Program, postponethe targeted expiry date o the program by six months and purchase longer-

dated government bonds.Japans real GDP is expected to grow at a moderate pace through 2013,supported by reconstruction activity and government stimulus programs.Growth in economic activity is projected to slow in 2014, however, owing tothe drag rom a planned increase in the value-added tax. 3 Growth in exportsis projected to be restrained through 2014 by the elevated level o the yenand modest growth in oreign demand. Relative to the April Report , realGDP growth is expected to be stronger in 2012, but somewhat weakertherea ter.

Emerging-Market EconomiesEconomic growth in China is slowing to a greater degree than anticipatedat the time o the April Report ( Box 1 ). Real GDP growth moderated to7.6 per cent on a year-over-year basis in the second quarter o 2012, theweakest result in more than three years. The past tightening in monetaryand macroprudential policies has led to a broad deceleration in domesticdemand, while weaker external demand, especially rom Europe, hasweighed on export growth. In ation pressures are easing, with consumerprice in ation alling to 2.2 per cent in June, owing mainly to a moderation in

3 Japans value-added tax will be increased rom 5 per cent to 8 per cent in April 2014 and to 10 per centin October 2015.

U.S. business investment is

projected to gain momentum

Japans real GDP is expected to grow at a moderate pace

Economic growth in China is slowing to a greater degree than anticipated


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Box 1

Recent Developments in Emerging-Market EconomiesWith advanced economies experiencing a relatively slow

economic recovery typical o those ollowing large nancialcrises, emerging-market economies (EMEs) have becomekey drivers o global economic growth While growth inEMEs remains strong relative to that o advanced econ-omies, recent data suggest that economic activity in manyEMEs, most notably China, India and Brazil, has slowedmarkedly Overall, GDP growth in EMEs ell to 5 5 per centon a year-over-year basis in the rst quarter o 2012, con-siderably less than the 6 4 per cent annual rate o growthregistered in 2011 ( Chart 1-A ) While a slowdown wasexpected, its extent has surprised on the downside

The slowdown in EMEs re ects both external and domesticactors As anticipated in the April Report , weak demandin advanced economies is weighing on EME exportgrowth, which declined to 7 per cent on a year-over-yearbasis in 2011, down rom its pre-crisis average o 12 percent 1 Uncertainty surrounding the economic outlookin advanced economies is also contributing to negativecon dence e ects and volatile capital ows, leading toexchange rate depreciations and declines in equity prices 2 Given the weak external environment, domestic demandin EMEs is expected to be the primary driver o economicgrowth Consumption growth remains solid, supportedby low unemployment and rising wages However, invest-ment growth is moderating in the larger EMEs, owing to

the lagged e ect o past monetary tightening and otherpolicy measures intended to put investment on a moresustainable path In China, or example, authorities havemaintained tightening measures in the housing market andother speci c sectors (such as steel and cement) 3 In otherEMEs, such as India, the slow progress o structural re ormis dampening business con dence and constraining growthin potential output

In response to the slowdown in economic activity, author-ities in EMEs have begun easing the stance o scal andmonetary policies New scal stimulus measures are beingimplemented in China and Brazil, and most EMEs have thecapacity to engage in another round o limited stimulus,

1 The declines in exports rom EMEs to the euro area and China have beennotable (China is the main importer o many EME commodities and intermed-iate goods)

2 Given its trade and nancial links to the euro area, emerging Europe (CzechRepublic, Hungary, Poland, Romania and Russia) is experiencing signi cantnegative spillover e ects rom the ongoing sovereign debt crisis, particularlythrough euro-area bank deleveraging In other emerging-market regions( m g g as d l am ), d g w h m d s g hrst quarter o 2012

3 Tightening measures targeted at the housing sector include increased downpayments, a rise in mortgage rates and restrictions on the ownership o secondhomes

although there is less room to accommodate such measuresthan there was in 2008 Many EMEs have recently loweredpolicy interest rates, taking advantage o reduced in ationpressures Structural re orms are also expected to playan important role in supporting the growth o sustainabledomestic demand

EMEs account or a small but growing share o Canadasexports (9 per cent) More importantly, however, demandrom EMEs is the major driver o commodity prices and,hence, o Canadas terms o trade A slowdown in com-modity-intensive growth in EMEs, especially in China,would have a major impact on global commodity prices(Chart 1-B ) EME members o the G-20 purchase almost

70 per cent o global iron ore imports and about hal ocopper, zinc and aluminum imports ( Chart 1-C ) The latterthree metals make up most o Canadas base metal exportsSimilarly, EMEs have accounted or virtually all o the addi-tional demand or oil over the past several years Thus, theweaker outlook or growth in EMEs has likely played a sig-f h d p mm d p s. l k g

through short-term concerns about economic growth, how-ever, the Bank expects commodity prices to remain elevatedover the medium term as the global economy recovers

Note: Countries are weighted by their GDP shares based on International MonetaryFund estimates o the purchasing-power-parity (PPP) valuation o country GDPsor 2011.Sources: J.P. Morgan; IMF, World Economic Outlook , April 2012; and Bank oCanada calculations

2010 2011 2012Q1

0

2

4

6

8

10

12

Emerging-marketeconomies

China Brazil India

%

Chart 1-A: Growth in real GDP has slowed in emerging-market economiesYear-over-year percentage change, annual and quarterly data

(continued)


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Commodity Prices Although elevated by historical standards ( Chart 11 ), the prices o manycommodities have declined since the April Report , in response to weakeningworld economic prospects. Global oil prices have registered the largestdrop, alling by about 15 per cent since April. The latest utures curve sug-gests that Brent crude prices will decline gradually over the projectionhorizon, re ecting so ter demand conditions combined with expectations orobust production rom countries that are not part o the Organization o thePetroleum Exporting Countries (OPEC). The spread between West TexasIntermediate (WTI) and Brent prices is projected to narrow rom aboutUS$16 in the second quarter o 2012 to around US$7 by the end o 2014, asadditions to the pipeline network are expected to contribute to a partialresolution o oversupply conditions in the U.S. Midwest. Relative to the AprilReport , oil prices are expected to be substantially weaker through 2014,largely owing to diminished prospects or global demand ( Chart 12 ).

Although natural gas prices have rebounded since the April Report , boosted bygrowing demand or electricity generation, they are still very low by historicalstandards. Based on the latest utures curve, natural gas prices are expected tocontinue to rise through 2014, similar to expectations in April ( Chart 13 ).

Prices or most non-energy commodities have declined slightly since April andare generally projected to stay marginally below the levels anticipated at thetime o the last Report through 2014. Slowing growth in demand rom Chinaand the situation in the euro area have put signifcant downward pressureon the prices o base metals, which is expected to continue until early 2013.

The prices o many commodities have declined

Box 1 (continued )

Note: Energy use per unit o GDP is measured as units o energy consumed(equivalent to a kilogram o oil) per unit o GDP converted to 2005 constantinternational dollars using purchasing-power-parity (PPP) rates (an internationaldollar has the same purchasing power over GDP as a U.S. dollar in the UnitedStates). Countries included in the emerging-market grouping are weighted bytheir GDP shares based on World Bank estimates o the PPP valuation o countryGDPs or 2009.Source: World Bank

0.05

0.10

0.15

0.20

0.25

0.30Ratio

European Union United States G-20 emerging-market economies(excluding China)

China

Chart 1-B: Growth in emerging-market economies is moreenergy-intensive than in advanced economiesEnergy use per unit o GDP, 2009

Sources: UN Comtrade; IMF, World Economic Outlook , April 2012; andBank o Canada calculations

China G-20 emerging-market economies (excluding China)

0

10

20

30

40

50

60

70

80%

World GDP Crude oil Nickel Aluminum Coal Zinc Copper Iron ore

Chart 1-C: Emerging-market economies account or a largeshare o world commodity importsPercentage share o world GDP and world commodity import s, 2010


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Prices or base metals are then projected to increase slowly, supported by thepickup in global economic growth. As recent severe weather conditions havereduced supply, prices or agricultural products are expected to remain ele-vated or the remainder o 2012 and to decline therea ter. Owing to the gradualpace o the recovery in the U.S. housing sector and a moderation in demandrom China, prices or orestry products are expected to remain weak overthe projection horizon.

Source: Bank o Canada Last observation: 2012Q2

Real BCPI Historical average (1972 to present)

60

80

100

120

140

160

180

200

220

1972 1977 1982 1987 1992 1997 2002 2007 2012

Index

Chart 11: Commodity prices remain elevated by historical standardsBank o Canada commodity price index (BCPI) in real terms, 1972Q1 = 100, quarterly data

Spot price or W TI crude oil (13 July 2012)Front-month utures price or Brent crude oil (13 July 2012)Based on an average o utures contract s over the two weeks ending 13 July 2012

Note: Values or WTI crude oil prices in July 2012 are estimates based on the average daily spot prices up to13 July 2012. Values or Brent crude oil prices in July 2012 are estimates based on the average ront-monthutures prices up to 13 July 2012.

Source: Bank o Canada

Brent crude oilBrent utures priceBrent utures price(April Report )

WTI crude oilWTI utures priceWTI utures price(April Report )

30

50

70

90

110

130

2009 2010 2011 2012 2013 2014

US$/Barrel

Chart 12: Prices or crude oil have allen recently and are projected to remainbelow April expectations through 2014Monthly data


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Implications or the Canadian EconomyDemand or Canadas exports remains modest: the oreign activity measurehas recovered only slightly more than hal o the decline recorded during the200809 recession, largely owing to the weak U.S. recovery. 4 The oreignactivity measure is expected to grow steadily over the projection horizonand to outpace the growth in trade-weighted oreign GDP as well as U.S.

GDP ( Chart 14 ), re ecting sustained momentum in U.S. business investment

4 The oreign activity measure captures the composition o oreign demand or Canadian exports byincluding the components o U.S. private fnal domestic demand and economic activity outside o theUnited States.

The oreign activity measure is expected to grow steadily

Spot price or natu ral gas (13 July 2012)Based on an average o utures contract s over the two weeks ending 13 July 2012

Note: Values or natural gas prices in July 2012 are estimates based on the average daily spot prices up to13 July 2012.

Source: Bank o Canada

Natural gasNatural gas utures price

Natural gas utures price (April Report )

2007 2008 2009 2010 2011 2012 2013 20140

3

6

9

12

15US$/Million Btu

Chart 13: Prices or natural gas are expected to rise through 2014Monthly data

Sources: U.S. Bureau o Economic Analysis and Bank o Canada calculations and projections

Foreign real GDP (trade-weighted) U.S. real GDP Foreign act iv ity measure

2005 2006 2007 2008 2009 2010 2011 2012 2013 201480

85

90

95

100

105

110

115

Index

Chart 14: The oreign activity measure is expected to grow at a stronger pacethan trade-weighted oreign GDPIndex: 2007Q4 = 100, quarterly data


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spending and a gradual recovery in the U.S. housing market rom depressedlevels. The measure is projected to surpass its pre-recession level duringthe second hal o 2013. Relative to the April Report , the expected profle othe oreign activity measure is nonetheless lower through 2014, with thedownward revision to the outlook or global economic growth partly o setby the slightly more avourable composition o U.S. demand.

The methodology used to compute the Bank o Canadas commodity priceindex (BCPI) has recently been improved to incorporate more accurate com-modity weights and an expanded basket o benchmark oil prices to bettermeasure the prices received by Canadian oil producers ( Box 2 ). Thesemodifcations highlight the growing share o crude oil output and the shi taway rom natural gas in the total value o Canadian commodity production.

Based on the new methodology, the BCPI has declined by approximately6 per cent since April. Prices or Western Canada Select have allen by22 per cent since the April Report , a larger decline than in global prices, asstrong growth in production and temporary refnery and pipeline outageshave led to excess supply. These developments have caused a deteriorationin Canadas terms o trade. Over the projection horizon, the BCPI isexpected to increase, re ecting a sustained rise in natural gas prices and aslight narrowing o the gap between the price or Brent crude and North

American crude oil benchmarks. This is expected to have a positive impacton Canadas terms o trade.

Canadian DollarThe Canadian dollar has averaged 98 cents U.S. since the June fxedannouncement date ( Chart 15 ) and is assumed to remain at this level overthe projection horizon, compared with the 101 cents U.S. assumed in the

April Report .

Prices or Western CanadaSelect have allen by 22 per cent since the April Report

Note: A rise in either series indicates an appreciation o the Canadian dollar.Source: Bank o Canada Last observation: 13 July 2012

CERI: Canadian-dollar e ective exchange rate index(against U.S. dollar, euro, yen, U.K. pound, Mexicanpeso and Chinese renminbi) (le t scale, 1992 = 100)

Closing spot exchange rateor Canadian dollar vis--visU.S. dollar (right scale)

2008 2009 2010 2011 20120.75

0.80

0.85

0.90

0.95

1.00

1.05

1.10

90

100

110

120

130US$Index

Chart 15: The value o the Canadian dollar has declined since the last Report Daily data

April Report


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Box 2

Improving the Bank o Canada Commodity Price IndexThe Bank o Canada commodity price index (BCPI) contains

24 commodity prices that are signi cant or Canada It isconstructed using a Fisher chain methodology, and pricesor individual commodities are weighted by their value inCanadian commodity production 1 The BCPI is an importanttool or assessing (i) economic activity in Canadas resourcesector; (ii) aggregate commodity costs aced by Canadianproducers; and (iii) Canadas terms o trade The index hasrecently been improved with the incorporation o moreaccurate commodity weights and an expanded basket obenchmark oil prices

More accurate commodity weights

Most o the BCPI weights are constructed using datarom input-output tables computed by Statistics Canada,which are only available with a our-year lag (currently upto 2008) Until now, the weights were held constant attheir last historical values or those years where the input-output data were not yet available To better re ect recentCanadian commodity production and to help reduce thesize o annual historical revisions to the index, a procedurehas been developed or estimating the weights or themost recent years Speci cally, the percentage changein Canadian production values ( rom which the weightsare derived) is approximated by a gure representing theproduct o the annual percentage change in commodity

prices and an estimate o the change in Canadian produc-tion volume 2

An expanded basket o benchmark oil prices

The set o oil prices used in the construction o the BCPIhas been expanded to better re ect the prices received byCanadian producers These prices have recently divergedrom global benchmark prices, owing to logistical con-straints in the U S Midwest In addition to the West TexasIntermediate (WTI) component, the BCPI now incorporatesthe Brent benchmark, a representative price or light oilsproduced o shore in Eastern Canada, and Western Canada

1 For more in ormation, see I Kolet and R Macdonald, The Fisher BCPI: TheBank o Canadas New Commodity Price Index, Discussion Paper No 2010-6,Bank o Canada, 2010

2 Production volumes are proxied using available data rom a variety o ofcialsources, including Statistics Canada, Natural Resources Canada and theNational Energy Board

Crude, 3 the benchmark price or heavy oils produced inWestern Canada Each crude oil benchmark is weightedaccording to its production value in the BCPI, using the esti-mation method described above 4

The e ects o the updated weights and the expandedoil-price basket on the composition and level o the index

3 The Western Canada Crude Index is based on the Canadian Heavy Crude O il(Net Energy) Index traded daily on the Chicago Mercantile E xchange Since dataor historical indexes are not available be ore October 2010, the series is back-

casted using a combination o historical spot prices or Western Canada Selectand the historical growth rate o the West Texas Intermediate benchmark

4 For 2012, the relative weights o the crude oil components are 52 per cent or

West Texas Intermediate (WTI), 36 per cent or Western Canada Crude and11 per cent or Brent The W TI component includes both conventional light oilsand synthetic light oils (upgraded bitumen) produced in Western Canada Thesmall weight attributed to Brent re ects the limited share o eastern o shore oilproduction in the total volume o Canadas oil production Brent is rep resent-ative o a much higher share o the mix o crude oil imported into Canada,however, making it an important determinant o Canadas terms o trade

* Estimated weights using new methodology** Defned as the aggregation o fsheries products and coalSources: Statistics Canada, Fisheries and Oceans Canada, Natural ResourcesCanada, and Bank o Canada calculations Last observation: 2012

Crude oilNatural gasMetals

AgricultureForestryOther**

1972 1977 1982 1987 1992 1997 2002 2007 2012*0

10

20

30

40

50

60

70

80

90

100

%

Chart 2-A: The new weighting methodology or the BCPIhighlights the increase in the share o oil in the past ew years

Value shares in Canadian commodit y producti on, annual da ta

(continued)


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C eco omWhile global headwinds are restraining Canadian economic activity,domestic actors are expected to support moderate growth in Canada. TheBank expects the Canadian economy to grow at a pace roughly in line withits production potential in the near term, be ore picking up through 2013.The Bank continues to anticipate that, over the projection horizon, theexpansion will be driven mainly by growth in consumption and businessinvestment, re ecting very stimulative domestic fnancial conditions.Housing activity is expected to slow rom record levels. Canadian exportsare projected to remain below their pre-recession peak until the beginning o2014, re ecting the dynamics o oreign demand and ongoing competitive-ness challenges, including the persistent strength o the Canadian dollar.

This outlook or the Canadian economy is weaker over the near term thananticipated in the April Report . The projected growth in household expendi-tures and business investment has been revised somewhat lower, largelyowing to the reintensifcation o external headwinds, notably the e ects olower commodity prices on Canadian incomes and wealth. The projectedgrowth in exports is also weaker than in the April Report , in line with the

more subdued outlook or oreign demand. As a result, the Canadianeconomy is expected to continue to operate with a small amount o slackor somewhat longer than previously anticipated.

The Bank continues to orecast that core in ation will remain around2 per cent over the projection horizon as the economy operates near itsproduction potential, the growth o labour compensation stays moderateand in ation expectations remain well anchored. Re ecting lower prices orgasoline, total CPI in ation is expected to remain noticeably below the2 per cent target over the coming year, be ore returning to target aroundmid-2013.

Financial ConditionsDespite the deterioration in global fnancial conditions, the supply and priceo credit or businesses and households in Canada remain very stimulative( Chart 16 ), providing important ongoing support to the economic expansion.

Canadian fnancial markets have remained resilient in recent months,although they have been a ected by heightened risk aversion and volatilityin global markets. Most notably, the S&P/TSX Composite Index has declinedby roughly 10 per cent rom its frst-quarter peak and volatility has increased( Chart 17 ). Credit spreads on Canadian corporate bonds have also widened

The Bank expects theCanadian economy to grow

at a pace roughly in linewith its production potential

in the near term, be ore

picking up through 2013

Core infation is projected to remain around 2 per cent

Total CPI infation is expected to remain noticeably belowthe 2 per cent target over thecoming year, be ore returningto target around mid-2013

The supply and price o credit or businesses and

households in Canada remain very stimulative

19 Canadian eCOnOMy BANK OF CANADA Monetary Policy rePort July 2012

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somewhat, although all-in yields have allen as yields on Canadian govern-ment bonds have declined to record lows, and the volume o bond issuancehas remained robust.

Canadian banks continue to be well positioned to lend, with ready access torelatively low-cost unding across the term structure in both Canadian andoreign currencies. The Banks latest Senior Loan O cer Survey (availableon the Banks website under Publications and Research > Periodicals > SLOS 2012Q2) and the balance o opinion o Canadian frms surveyed in the

Canadian banks continue to be well positioned to lend

Note: For more in ormation on these series, see < http://credit.banko canada.ca/fnancialconditions >.Source: Bank o Canada calculations Last observation: 13 July 2012

E ective business interest rate E ective household interest rate

2008 2009 2010 2011 2012

%

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

Chart 16: Borrowing costs or businesses and households remainat exceptionally low levelsWeekly data

Note: The S&P/TSX 60 covers approximately 73 per cent o Canadas equity market capitalization.The S&P/TSX 60 VIX is a measure o the 30-day implied volatility obtained rom options contracts on theS&P/TSX 60 Index.


S&P/TSX Composite (le t scale) S&P/TSX 60 VIX (right scale)

0

5

10

15

20

25

30

35

40

2011 2012

%Index points

Jan Apr Jul Oct Jan Apr Jul11000

11500

12000

12500

13000

13500

14000

14500

15000

Chart 17: Since the last Report , equities have declined while volatility has increased

April Report

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Banks summer Business Outlook Survey (available on the Banks websiteunder Publications and Research > Periodicals > BOS Summer 2012 ) together suggested little change in business lending conditions in recentmonths, ollowing several quarters o persistent easing ( Chart 18 ).

In the context o these broadly avourable fnancing conditions or Canadianfrms, the growth o overall business credit has picked up to a rate above itshistorical average ( Chart 19 ). Growth in short-term business credit has been

a. Weighted percentage o sur veyed fnancial institutions reporting tightened credit conditions minus theweighted percentage reporting eased credit conditions

b. Percentage o frms reporting tightened credit conditions minus the percentage reporting eased creditconditions


Overall business-lending conditions rom the Senior Loan O cer Survey aOverall credit conditions rom the Business Outlook Survey b

2007 2008 2009 2010 2011 2012

-60

-40

-20

0

20

40

60

80

100

%

Tightening

Easing

Chart 18: Survey results suggest that credit conditions or Canadian rmsremain very stimulativeBalance o opinion

Source: Bank o Canada Last observation: May 2012

Total business creditHistorical average o businesscredit growth rom 1992 to present

Total household creditHistorical average o household creditgrowth rom 1992 to present

2008 2009 2010 2011 2012-4

-2

0

2

4

6

8

10

12

14

%

Chart 19: The growth o business credit has rmed, while household creditgrowth has slowed somewhat3-month percentage change (at annual rates)

http://www.bankofcanada.ca/?page_id=28148http://www.bankofcanada.ca/?page_id=28148http://www.bankofcanada.ca/?page_id=28148http://www.bankofcanada.ca/?page_id=28148

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particularly strong, while growth in long-term business credit has remainedmoderate. These developments are consistent with the ongoing solid growthin business investment and the ample availability o internal unds owing tothe strong balance-sheet positions o non-fnancial frms.

Although household credit also continues to be readily available at near-

record low rates, the pace o growth in household credit has slowed some-what since the latter part o 2011 ( Chart 19 ). Nonetheless, this ollows anextended period o rapid growth in household credit, and the particularlystrong activity in the housing market seen early in 2012 suggests somere-acceleration in mortgage credit in the near term. 5

Compared with the unusually rapid pace observed in late 2011, growth in thenarrow monetary aggregates has moderated in recent months, consistentwith reduced liquidity pre erence. Growth in the broad monetary aggregateshas been moderate over the same period, suggesting relatively subduedin ation pressures ahead.

Estimated Pressures on CapacityThe Canadian economy continues to operate with a small amount o sparecapacity. Real GDP grew by 1.9 per cent in the frst quarter o 2012 and isestimated to have grown at a similar pace in the second quarter, bothbroadly in line with the estimated growth o the economys productionpotential, thus maintaining the small degree o economic slack that existedat the end o 2011. This was a somewhat so ter pace o growth than theBank had expected, however, largely re ecting slightly weaker consumptionand business investment, as well as temporary actors such as disruptionsin the energy sector. As a result, economic slack was not absorbed throughthe frst hal o 2012 as previously projected, with the level o real GDP in thesecond quarter 0.4 per cent below the level anticipated in the April Report .These dynamics are re ected in the evolution o the Banks conventional

measure o the output gap, which has been broadly stable in recent quar-ters at around -0.5 per cent ( Chart 20 ).

Taken together, other indicators o pressures on capacity also point to thepersistence o a small degree o slack in the Canadian economy. Responsesto the Banks Business Outlook Survey in recent quarters have shownthat the proportion o frms that would have di fculty responding to anunexpected increase in demand has stayed close to its historical average,while the proportion o frms reporting labour shortages in the Bankssummer Business Outlook Survey has remained somewhat below its histor-ical average. Despite notable increases in employment in March and April,the unemployment rate has remained close to the levels prevailing aroundmid-2011 ( Chart 21 ), and the proportion o involuntary part-time workerscontinues to be elevated.

On balance, the Bank judges that the economy was operating at roughlyhal o a per cent below its production capacity in the second quarter o2012. This is the same degree o slack as estimated in the frst quarter, andis slightly greater than had been anticipated in the April Report or thesecond quarter.

5 There is usually a lag o one to six months between the sale o a house and the reporting o the trans-action in mortgage credit statistics, which re ects the time peri od between the fnalization o the saleand when the homeowner takes possession o the unit.

Household credit continues

to be readily available at near-record low rates

The Canadian economy continues to operate with a

small amount o spare capacity

On balance, the Bank judgesthat the economy was operating

at roughly hal o a per cent below its production capacity in the second quar ter o 2012


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a. Response to Business Outlook Survey question on capacity pressures. Percentage o frmsindicating that they would have either some or signifcant di fculty meeting an unanticipatedincrease in demand/sales.

b. Response to Business Outlook Survey question on labour shortages. Percentage o frms reportinglabour shortages that restrict their abilit y to meet demand.

c. Di erence between actual output and estimated potential output rom the Bank o Canadas conven-tional measure. The estimate or the second quarter o 2012 (indicated by * ) is based on a p rojectedincrease in output o 1.8 per cent (at annual rates) or the quarter.


Some and signifcant di fculty a (le t scale)Labour shortages b (le t scale)

Conventional measure othe output gap c (right scale)

-4

-3

-2

-1

0

1

2

3

0

10

20

30

40

50

60

70

2007 2008 2009 2010 2011 2012

%%

Chart 20: A small amount o excess supply remains in the Canadian economy

Source: Statistics Canada Last observation: June 2012

Employment (le t scale) Unemployment rate (right scale)

4

5

6

7

8

9

2008 2009 2010 2011 201216600

16800

17000

17200

17400

17600

%Thousands

Chart 21: Despite employment gains, labour indicators are consistentwith some slackMonthly data


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The Real EconomyThe Bank expects the Canadian economy to grow at a pace roughly in linewith its production potential in coming quarters, be ore picking up therea ter( Chart 22 ). On an average annual basis, real GDP growth is orecast toincrease slightly rom 2.1 per cent in 2012 to 2.3 per cent in 2013 and

2.5 per cent in 2014 ( Table 2 ). This outlook or growth is weaker over thenear term than in the April Report ( Table 3 ).

The Bank continues to anticipate that consumption and business fxedinvestment will be the primary drivers o growth in real GDP over the projec-tion horizon, supported by accommodative domestic fnancial conditions( Chart 23 ). Following surprising recent strength, housing investment isexpected to slow, contributing to a more balanced composition o economic

On an average annual basis, real GDP growth is forecast to increase slightly from 2.1 per cent in 2012 to 2.3 per cent in

2013 and 2.5 per cent in 2014

Table 2: Contributions to average annual real GDP growthPercentage points a

2011 2012 2013 2014

Consumption 1.4 (1.3) 1.1 (1.3) 1.2 (1.3) 1.2 (1.2)

Housing 0.2 (0.2) 0.4 (0.3) 0.0 (0.2) 0.0 (0.1)

Government 0.1 (0.2) -0.3 (0.0) 0.3 (0.1) 0.3 (0.1)

Business xed investment 1.4 (1.5) 0.5 (0.9) 0.8 (0.7) 0.8 (0.7)

Subtotal: Final domestic demand 3.1 (3.1) 1.7 (2.5) 2.3 (2.3) 2.3 (2.1)

Exports 1.4 (1.3) 1.3 (1.7) 1.0 (1.1) 1.4 (1.3)

Imports -2.2 (-2.1) -0.9 (-1.5) -0.9 (-1.0) -1.2 (-1.2)

Subtotal: Net exports -0.8 (-0.7) 0.4 (0.2) 0.1 (0.1) 0.2 (0.1)

Inventories 0.1 (0.1) 0.0 (-0.3) -0.1 (0.0) 0.0 (0.0)

GDP 2.4 (2.5) 2.1 (2.4) 2.3 (2.4) 2.5 (2.2)

Memo items:

Potential output 1.6 (1.6) 2.0 (2.0) 2.1 (2.1) 2.2 (2.2)

Real gross domestic income (GDI) 3.8 (3.7) 1.6 (2.2) 2.3 (2.5) 2.3 (2.4)

a. Figures in parenth eses are rom the base-case projection in the April 2012 Monetary Policy Report . Thoseor potential output a re rom Technical Box 2 in the October 2011 Monetary Policy Report .

Table 3: Summary of the base-case projection for Canada a

2011 2012 2013 2014

Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

Real GDP (quarter-over-quarter percentage change at annual rates)

1.9(1.8)

1.9(2.5)

1.8(2.5)

2.0(2.4)

2.3(2.5)

2.3(2.5)

2.4(2.2)

2.6(2.3)

2.7(2.2)

2.5(2.2)

2.3(2.2)

2.2(2.2)

2.2(2.2)

Real GDP (year-over-year percentagechange)

2.2(2.2)

1.8(2.0)

2.5(2.7)

1.9(2.3)

2.0(2.5)

2.1(2.5)

2.3(2.4)

2.4(2.4)

2.5(2.3)

2.6(2.2)

2.6(2.2)

2.4(2.2)

2.3(2.2)

Core infation (year-over-year

percentage change)2.1(2.1)

2.1(2.1)

2.0(1.9)

1.9(1.8)

1.9(1.8)

1.9(1.8)

2.0(2.1)

2.0(2.1)

2.1(2.1)

2.1(2.1)

2.0(2.0)

2.0(2.0)

2.0(2.0)

Total CPI (year-over-year percentagechange)

2.6(2.6)

2.4(2.4)

1.7(2.0)

1.2(2.2)

1.6(2.2)

1.5(2.1)

1.5(1.9)

2.0(1.9)

2.0(1.9)

2.0(1.9)

2.0(2.0)

2.0(2.0)

2.0(2.0)

Total CPI excluding the e ect o theHST and changes in other indirect taxes(year-over-year percentage change)

2.5(2.5)

2.2(2.3)

1.6(1.9)

1.1(2.1)

1.5(2.1)

1.5(2.1)

1.6(2.0)

2.1(2.0)

2.1(2.0)

2.1(2.0)

2.0(2.0)

2.0(2.0)

2.0(2.0)

WTIb (level) 94(94)

103(103)

93(103)

86(104)

87(105)

88(105)

89(105)

89(104)

89(103)

88(102)

88(101)

87(99)

87(99)

Brent b (level) 109(109)

118(118)

109(122)

100(121)

99(119)

98(117)

98(115)

98(113)

97(112)

96(110)

96(108)

95(106)

94(104)

a. Figures in parentheses are from the base-case projection in the April 2012 Monetary Policy Report .b. Assumptions for the prices of West Texas Intermediate and Brent crude oil (US$ per barrel), based on an average of futures contracts over the two weeks ending 13 July 2012

24 Canadian EConomy BANK OF CANADA Monetary Policy rePort July 2012

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growth than has been seen in recent quarters. Overall, the outlook ordomestic demand is weaker than in the April Report , although the revisionsare relatively small, since Canadian business sentiment and householdconfdence have held up relatively well despite rising global uncertainty( Chart 24 ). The Bank continues to expect little contribution to economicgrowth rom net exports over the orecast horizon, with roughly o settingdownward revisions to exports and imports in this projection.

While growth in household spending has been moderate in recent quarters,it has been disproportionately supported by housing investment, which isaround historical highs and showing signs o overbuilding. The growth oconsumption has slowed, together with the growth o disposable income,but housing investment has strengthened urther, with both the construction

The growth o consumption has slowed, but housing investment has strengthened urther

Sources: Statistics Canada and Bank o Canada calculations and projections

Year-over-year percentagechange in real GDPBase-case projection

Quarter-over-quarter percentagechange in real GDP, at annual ratesBase-case projection

2008 2009 2010 2011 2012 2013 2014-10

-8

-6

-4

-2

0

2

4

6

8

%

Chart 22: Real GDP is expected to grow at a moderate pace


ConsumptionHousing

Business fxed investmentGovernment

Net exportsInventories

GDP

2009 2010 2011 2012 2013 2014-6

-4

-2

0

2

4

6

-6

-4

-2

0

2

4

6

Percentage points

Chart 23: Private domestic demand is projected to account or most oCanadas economic growthContributions to real GDP growth


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o new multiple- amily dwellings ( Chart 25 ) and renovation activityexpanding robustly. In this context, the household debt-to-income ratio hascontinued to rise, reaching a record high in the frst quarter o 2012.

The Bank anticipates that growth in household expenditures will rely less onhousing investment over the projection horizon. Growth in consumption isexpected to rebound slightly rom its modest pace through the frst hal o2012, growing at a rate just below that o disposable income through 2014

The household debt-to-income ratio has continued to rise

a. Percentage o frms expecting aster growth minus the percentage expecting slower growthSources: Con erence Board o Canada and Bank o Canada Last observations: 2012Q2 and June 2012

Response to Business Outlook Survey question on expectations or salesgrowth over the next 12 months relative to the past 12 months (balance oopinion, a quarterly data, le t scale)Consumer confdence (all respondents, index: 2002 = 100, monthly data,right scale)

2 00 2 2 00 3 2 00 4 2 00 5 2 00 6 2 00 7 2 00 8 2 00 9 2 01 0 20 11 2 01 240

50

60

70

80

90

100

110

-40

-30

-20

-10

0

10

20

30

40

50

60

Index%

Chart 24: Despite external events, consumer confdence and businesssentiment have held up in recent months

Sources: Canada Mortgage and Housing Corporation andBank o Canada calculations Last observation: 2012Q2

Single- amily housing starts Multiple- amily housing starts

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 20120

25

50

75

100

125

150

175

200

Thousands of units

Chart 25: New construction o multiple- amily dwellings is contributingimportantly to housing activity Housing starts, quarterly data


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( Chart 26 ), resulting in a slight increase in the personal savings rate( Chart 27 ). In contrast, housing investment is projected to slow, with itsshare o the overall economy moderating somewhat rom the currentunusually elevated level ( Chart 28 ). In this regard, the additional prudent andtimely measures recently announced by ederal authorities are expected tocontribute to a more sustainable evolution o housing market activity inCanada. 6

6 The ederal government announced our measures or new government-backed insured mortgageswith loan-to-value ratios o more than 80 per cent, e ective 9 July. The new measures: (i) reduce themaximum amortization period to 25 years rom 30 years; ( ii) lower the maximum amount Canadianscan borrow when refnancing to 80 per cent rom 85 per cent o the value o their homes; (iii) fx themaximum gross debt-service ratio at 39 per cent and the maximum total debt-service ratio at44 per cent; and (iv) limit the availability o government-backed insured mortgages to homes with apurchase price o less than $1 million.

Housing investment is projected to slow


Personal disposable income Nominal consumption

2007 2008 2009 2010 2011 2012 2013 2014-2

0

2

4

6

8

10

%

Chart 26: Moderate growth in personal disposable income is expectedover the projection horizonYear-over-year percentage change, quarterly data

Sources: Statistics Canada and Bank o Canada projections

1975 1980 1985 1990 1995 2000 2005 2010 20150

5

10

15

20

25

%

Chart 27: The personal savings rate is expected to rise slightly but to remain lowQuarterly data


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The outlook or growth in household expenditures is slightly weaker in thisprojection than in the April Report , owing in part to the impact o the moresubdued global economic and fnancial environment on Canadian incomesand wealth. Despite the lower orecast or household spending, however, theBank continues to expect urther increases in the household debt-to-incomeratio in coming quarters.

The Bank continues to orecast solid growth in business fxed investment overthe projection horizon. This re ects the strong fnancial positions o Canadianfrms ( Chart 29 ), avourable credit conditions and the strong Canadian dollar,as well as the impetus to improve productivity amid heightened pressures tobecome more competitive. This orecast is consistent with the positive

The Bank continues toorecast solid growth in

business xed investment


The ratio o nominal residentialinvestment to nominal GDP

Average rom 1975Q1 to present

1975 1980 1985 1990 1995 2000 2005 2010 20150.03

0.04

0.05

0.06

0.07

0.08

Ratio

Chart 28: The share o residential investment in GDP is expected to moderatesomewhat rom its high levelQuarterly data

Source: Statistics Canada Last observation: 2012Q1

Debt-to-equity ratio

1995 1997 1999 2001 2003 2005 2007 2009 20110.8

0.9

1.0

1.1

1.2

1.3

Ratio

Chart 29: With leverage at historic lows, non- nancial rms remain wellpositioned to investQuarterly data


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responses to the Banks summer Business Outlook Survey ( Chart 30 ).Relative to the April Report , the projected profle or business investment isless robust, partly re ecting recent sharp declines in commodity prices andthe more subdued global economic outlook. Nonetheless, with the level ocommodity prices expected to stay elevated, the outlook or major invest-ments in the resource sector remains strong.

Government spending is projected to subtract rom real GDP growth in2012. This drag on economic growth is larger than in the April Report ,as signifcant urther downward revisions to national accounts estimateso government expenditures in recent quarters suggest a more rapidunwinding o the fscal stimulus measures enacted during the recessionthan previously estimated. Modest contributions to growth are expected in2013 and 2014, although these contributions are projected to be consider-ably weaker than has been typical historically ( Chart 31 ), in line with theplans o ederal and provincial governments to consolidate spending.

The recovery in net exports is expected to remain weak. Growth in Canadasexports is projected to remain moderate despite steady growth in oreign

activity ( Chart 14

), owing to ongoing competitiveness challenges, includingthe persistent strength o the Canadian dollar ( Box 3 ). As a result, the levelo Canadas exports is not orecast to regain its pre-recession peak until thebeginning o 2014 ( Chart 32 ). Growth in imports is expected to be moremoderate than previously anticipated, largely as a result o the weaker near-term outlook or consumption and business investment in Canada. Overall,as in the April Report, the projected contribution rom net exports to realGDP growth is marginal.

Given the above projection or real GDP, the Canadian economy is expectedto reach ull capacity in the second hal o 2013, thus operating with a smallamount o slack or somewhat longer than previously anticipated.

Relative to the April Report , the projected pro le or business investment is less robust

The recovery in net exports is expected to remain weak

The Canadian economy isexpected to reach ull capacity

in the second hal o 2013

a. This underlying measure is a summary o the responses to all o the BOS questions.See L. Pichette and L. Rennison, Extracting In ormation rom the Business Outlook Survey : A Principal-Component Approach, Bank o Canada Review (Autumn 2011): 2128.Sources: Statistics Canada and Bank o Canada calculations and projections

BOS indicator a (le t scale) Business fxed investment(quarterly growth at annual rates, right scale)

2007 2008 2009 2010 2011 2012 2013 2014-50.0

-37.5

-25.0

-12.5

12.5

0.0

25.0

-8

-6

-4

-2

0

2

4

%Standardized units

Chart 30: Business xed investment is projected to grow solidly, consistentwith responses to the Banks Business Outlook Survey Quarterly data


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Contribution o government expendituresto real GDP growth

Base-case projection

2000 2002 2004 2006 2008 2010 2012 2014-0.5

0.0

0.5

1.0

1.5

Percentage points

Chart 31: The contribution o government spending to real GDP growth isexpected to be modest

Annual da ta


Current cycleBase-case scenario

Average o previous cycles (since 1951)Range o previous cycles (since 1951)

-1 0 1 2 3 4 5 680

90

100

110

120

130

140

150

160

170

Index

Chart 32: The recovery in exports is expected to remain weakComparison o real exports across economic cycles; quarter be orethe downturn in real GDP = 100, quarterly data

Quarterly peak in real GDPbe ore the downturn

Yearsbe ore thedownturn

Yearsa ter thedownturn


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Box 3

Canadas Share o the Global Export MarketCanadas global market share o goods exports has declined

markedly in recent years, rom a peak o 4 5 per cent in2000 to 2 7 per cent in 2010 ( Chart 3-A ) While Canadianrms have been acing competitiveness challenges resultingrom the persistent strength o the Canadian dollar and poorproductivity per ormance relative to major trade competi-tors, other actors, such as to whom Canada sells its prod-ucts and the products it sells, have also signi cantly a ectedthe per ormance o Canadian exports These trends are inthe context o the urther opening o world trade amongemerging and developing economies, which has intensi edglobal competitive pressures

The structure o the geographic market to which Canadaexports, with a large weight on the relatively slow-growingU S market, and a small weight on other economies, particu-larly the relatively ast-growing emerging-market economies,has exerted the majority o the overall net negative impacton Canadian exports (roughly three-quarters o the totalnet impact, Table 3-A ) 1 Competitiveness e ects have alsoaccounted or a signi cant portion o the decline in Canadasshare o the world market, with adverse e ects registeredin most product categories 2 In this regard, the competitive-ness o Canadian rms was eroded by a substantial deteri-oration in their relative unit labour costs On the other hand,the structure o the product market or Canadian exports,

with a higher concentration in energy and non-energy com-

modities and automotive products than the world average,has provided support to Canadas global market share

Competitiveness challenges and the lack o diversi cationin trading partners will likely remain key issues or Canadianexports over the projection horizon

Table 3-A: Explaining the di erence between the growth o Canadas exports and world exportsIn percentage points

Annualaverage

Difference between thegrowth of Canadian and

world exportsCompetitiveness

effect a

Structure effect

Product effect bGeographic

market effect c Mixed effect d

200110 -4.8 -1.7 1.1 -3.7 -0.5

a. The competitiveness e ect is the change in export market share removing the e ects o Canadas geographic and product expor t structure.b. The product e ect measure s the contribution o the composition o Canadas export products to changes in its global market share. It is the change in the

aggregate export share that would have occurred i Canadas share had remained constant in each product market.c. The geographic market e ect measures the contribution o the composition o Canadas geographic export market to changes in its global market share. It is

the change in the aggregate export share that would have occurred i Canadas share had remained constant in each geographic market.d. The mixed e ect is a residual that re ects the interaction between the product and geographic market e ects.

Sources: UN Comtrade andBank o Canada calculations Last observation: 2010

Canadas world export market share (le t scale)Canadas export growth (annual percentage change, U.S. dollars,right scale)World export growth (annual percentage change, U.S. dollars,right scale)

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010-40

-30

-20

-10

0

10

20

30

40

0

1

2

3

4

5

6

%%

Chart 3-A: Exports o goods Annual data

1 D de Munnik, J Jacob and W Sze, The Evolution o Canadas Global Export

Market Share, Bank o Canada Workinvg Paper ( orthcoming), assess the role ocompetitiveness as well as that o the product and geographic market structurein explaining changes in Canadas world export market share since 1990

2 However, Canadas exports bene ted rom positive competitiveness e ects inenergy commodities, re ecting the substantial increase in Canadian crude oilproduction, together with expanded pipeline capacity to U S markets


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declines in world oil prices on gasoline prices in Canada. With utures pricessuggesting the persistence o lower oil prices than had been anticipated at thetime o the April Report , the Bank now expects total CPI in ation to remainnoticeably below the 2 per cent target over the coming year be ore returning tothe target around mid-2013.

The Bank now expectstotal CPI infation to remain

noticeably below the 2 per cent target over the coming

year be ore returning to thetarget around mid-2013

Note: Dotted lines indicate projections.a. CPI excluding eight o the most volatile components and the e ect o changes in indirect taxes on

the remaining componentsSources: Statistics Canada and Bank o Canada calculations and projections

Total CPI Core CPI a Target Control range

-2

-1

0

1

2

3

4

2007 2008 2009 2010 2011 2012 2013 2014

%

Chart 34: Core CPI infation is expected to be steady, while total CPI infation inCanada is projected to remain noticeably below 2 per cent over thecoming yearYear-over-year percentage change, quarterly data

Note: The 2012Q2 number or the e ective annual increase in base wage rates or newly negotiatedsettlements is approximated by April data.Sources: Statistics Canada andHuman Resources and Skills Development Canada Last observations: 2012Q1 and 2012Q2

E ective annual increase in base wage rates or newly negotiated settlements (all industries)Compensation per hour (year-over-year percentage change)Average hourly earnings o permanent workers (year-over-year percentage change)

2007 2008 2009 2010 2011 20120

1

2

3

4

5

6

%

Chart 35: Increases in labour compensation have generally been moderatein recent quartersQuarterly data


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R o O ooThe in ation outlook in Canada is subject to signifcant risks. In particular,the Banks projection assumes that authorities in Europe are able to containthe ongoing crisis, although this assumption is clearly subject to downsiderisks.

The three main upside risks to in ation in Canada relate to the possibility ohigher global in ationary pressures, stronger Canadian exports and strongermomentum in Canadian household spending.

Global in ationary pressures could be more persistent than currently projected i potential output in advanced economies is lower than anticipatedor i agricultural and other commodity prices are stronger than projected.

Growth in Canadian exports could be stronger than expected, and morein line with the anticipated growth in oreign activity, i Canadian exportersimprove their competitiveness more rapidly than currently assumed.

Residential investment in Canada has surprised on the upside, reachingrecord-high levels, and could have more momentum than currentlyprojected.

The three main downside risks to in ation in Canada relate to the Europeancrisis, weaker global momentum and the possibility that growth in Canadianhousehold spending could be weaker.

Failure to contain the crisis in Europe is the most serious risk acing theglobal and Canadian economies. The e ects on Canada through fnan-cial, confdence and trade channels would be substantial, given the sizeand importance o the euro area to the global economy.

Demand or Canadian exports could be weaker than expected i author-ities in the United States do not smooth the path o fscal consolidation toavoid the fscal cli or i the slowdown in emerging-market economies isgreater than expected.

Continuing high household debt levels in Canada could lead to a sharper-than-expected deceleration in household spending. Relatedly, i therewere a sudden weakening in the Canadian housing sector, it could havesizable spillover e ects on other areas o the economy.

Overall, the Bank judges that the risks to the in ation outlook in Canada areroughly balanced over the projection period.

35 Risks tO the OutlOOk BANK OF CANADA Monetary Policy rePort July 2012

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Mpr July2012