The Weekly Bottom Line

HIGHLIGHTS OF THE WEEK

United States

In a surprise move, the People's Bank of China (PBC) cut its benchmark rate by 0.25 pp for the first time since 2008. More important than the rate cut were hints by Chinese leaders that they will expand loans for new infrastructure projects.It is not clear that it is the right policy choice for China. The biggest concern is that it could continue feeding a credit-bubble that may grow too big to deflate in an orderly fashion.By contrast, deficit-plagued western economies could benefit from more active fiscal policymaking. The U.S. has underinvested in infrastructure throughout the recession and recovery, leaving an array of economically productive projects for the taking. Fiscal policy is not solely about spending money. In Europe, for example, a stronger fiscal union, with centralized taxing authority and budgetary oversight, could end the current crisis and minimize the risk of future ones like it.

Canada

The Bank of Canada held rates steady at 1.00%. The wording in the forward looking statement surrounding the eventual need for some withdrawal of stimulus was left unchanged.Canada's trade balance swung from a surplus position into a deficit position in April, as exports fell and imports edged up slightly.Canadian employment was essentially flat in May, with only 7,700 jobs created. This comes on the heels of two months of strong gains. The unemployment rate remained steady at 7.3%.Housing starts slid 13% in May, but at 211,400 units, was still one of the highest levels recorded postrecession.The CFIB Business Barometer Index edged down for a second consecutive month in May, coming in at 64.8. This is the lowest level the index has seen since November, and is slightly below the 65-75 range that is typically seen when the economy is growing.

Major central banks across the globe were on the offensive this week, even if only in words. In Thursday's testimony before the Joint Economic Committee, Chairman Bernanke entreated lawmakers to do more to support the U.S. economic recovery, saying “I'd be much more comfortable if Congress would take some of this burden from us.” Across the Atlantic, after announcing interest rates would remain on hold at 1%, ECB Chief Mario Draghi chastised policymakers for not being aggressive enough in solving Europe's crisis. But not all central bankers simply talked the talk. In a surprise move, the People's Bank of China (PBC) cut its benchmark rate by 0.25 pp for the first time since 2008. The move comes in advance of a slew of economic data set to be released by the state statistical agency this weekend, including inflation.

The PBC was reacting to signs that China's economy has slowed in recent months. Given the once-in-a-generation political transition currently underway, it is no surprise that authorities are intent on maintaining economic continuity. More important than the rate cut were hints by Chinese leaders that they will expand loans for new infrastructure projects.

In China, it seems, fiscal stimulus is back on the table. But while the case for fiscal stimulus in the West is strong, it is not clear that it is the right policy choice for China. The biggest concern is that it could continue feeding a creditbubble that may grow too big to deflate in an orderly fashion. The government often carries out its stimulus projects by intervening in the state-sponsored banking system, dictating lending terms, and picking winners and losers. After several years of this, there are few productive projects left. As a result, many of the loans sitting on (and off) bank balance sheets have gone to finance projects of dubious economic viability. If China's economy were to slow substantially, these loans could quickly turn bad and force authorities to swiftly intervene to backstop the banks. Still, a hard landing in China could have negative implications for the global economy.

By contrast, deficit-plagued western economies could benefit from more active fiscal policymaking. The U.S. has underinvested in infrastructure throughout the recession and recovery, leaving an array of economically productive projects for the taking. Upgraded rail networks and better seaport capacity could all be financed today at negative real interest rates. But fiscal policy is not solely about spending money. In Europe, for example, a stronger fiscal union, with centralized taxing authority and budgetary oversight, could end the current crisis and minimize the risk of future ones like it.

Instead, China and the West continue to fall back on the same familiar, and increasingly less potent, tools of economic policy management. Fiscal stimulus in China risks undermining the health of its banking system. In the U.S., overstretched monetary policy risks a costly distortion of financial markets in pursuit of only marginal benefits to the real economy. All the while, political indecisiveness keeps economies on both sides of the Atlantic from growing at their full potential.

Both Bernanke and Draghi have been vocal about the limitations of monetary policy when fiscal policy is not a partner in the process. No doubt the majority of fiscal policymakers see that too. Chinese leaders also realize their economic model is unsustainable. Yet rather than trying something new and different to spur growth, all signs so far point to more of the same.

After setting the stage for higher interest rates at the fixed announcement date in April, the Bank of Canada has once again found itself caught between a rock and a hard place. The recent deterioration in financial and economic conditions in Europe, if not contained, poses a serious risk to global financial markets and global economic growth. And, even if European leaders are able to keep the crisis confined within its borders, the likelihood of ongoing volatility in equity, commodity, bond and foreign exchange markets will continue to impact confidence and growth around the world.

While the external risks loom large, Canada's domestic economy is holding up fairly well. Economic growth in the first quarter came in below expectations at 1.9% annualized; however, excess slack in the economy has continued to diminish. Moreover, with Canadian households more leveraged than ever - due in large part to ultra-low borrowing costs - the Bank of Canada has a compelling argument to hike rates.

So with external and domestic risks at odds, what's a central bank to do? Given the enormous amount of uncertainty surrounding the debt crisis in Europe, it's probably best for the Bank of Canada to sit still for the moment, and take a wait-and-see approach. And that's exactly what Governor Carney decided to do on Tuesday - the overnight rate was left unchanged at 1.00%, as was the wording in the forward looking statement surrounding the eventual need for some withdrawal of stimulus.

The Bank noted that the outlook for global growth had weakened amid the renewed turmoil in Europe and acknowledged that the slowdown in emerging market growth was quicker and more widespread than expected. It also stated that, although less balanced, momentum in the domestic economy remains largely in line with expectations. As such, any withdrawal of stimulus will be weighed against both external and domestic developments.

The slew of data released this morning provided further evidence of the disparity between external and domestic forces. The impact of slowing economic activity outside Canada weighed on April's international trade numbers, as a drop in exports pushed the trade balance from a surplus position into a deficit position. Still, the decline in exports was a largely a price story, as export volumes were up for a second consecutive month, which is favourable for GDP growth.

On the housing front, while new home starts were down last month, May's 211,400 unit tally is still one of the highest recorded since the recession, and remains well above the pace of household formation in Canada (roughly 180,000). With interest rates at such low levels, we suspect that housing starts will remain around the 200,000 mark, suggesting that residential construction will continue to be a key contributor to economic growth this year.

Employment was essentially flat in May, as only 7,700 jobs were created and the unemployment rate held steady at 7.3%. But, this comes on the heels of two months of stellar gains, leaving average job creation over the last six months at a healthy 28,000 positions. What's more, annual wage growth, which ticked up to nearly 3.0% in May, is now outpacing inflation - yet one more factor auguring for higher interest rates.

Overall, the current language from the Bank of Canada affords it the flexibility to begin hiking rates as soon as this year, or to hold off for longer, should conditions around the world deteriorate further. We remain of the view that, as long as external headwinds do not intensify, the next move from the Bank of Canada will come later this year, and it will be up.

Release Date: June 13, 2012April Result: Retail Sales 0.1% M/M; ex-autos 0.1% M/MTD Forecast: Retail Sales 0.1% M/M; ex-autos 0.2% M/MConsensus: Retail Sales -0.2% M/M; ex-autos 0.0% M/M

Despite the intensifying headwinds, US consumer spending activity has remained on a upward trajectory, though the pace of growth has slowed considerably from the buoyancy evident in the first few months of the year. In May, we expect retail sales to rise at a very modest 0.1% m/m, following a similar gain the month before. Notwithstanding the meagre pace of growth, the increase will mark two consecutive years of growth in this indicator, reflecting the resiliency in US household spending activity.

Much of the gains should come from a rebound in spending on building material and further gains in nonstore spending. Auto sales, however, should be weaker on the month, while the drop in gasoline prices should push spending at the pump down. Excluding autos, sales activity should rise at a slightly more respectable pace of 0.2% m/m, with core spending activity remaining unchanged. In the months ahead, we expect the pace of consumption activity to remain tepid, reflecting the headwinds from slowing growth momentum and the uncertainty coming from Europe.

Release Date: June 14, 2012April Result: CPI 0.0% M/M; Core CPI 0.2% M/MTD Forecast: CPI -0.1% M/M; Core CPI 0.2% M/MConsensus: CPI -0.2% M/M; Core CPI 0.2% M/M

Favorable seasonals should push the energy component of the consumer basket sharply lower in May, mostly on account of weaker gasoline prices, which we expect to decline by as much as 6.0% during the month. Food prices, however, should rise modestly, posting a 0.2% m/m gain, partially offsetting the weakness in energy prices. During the month, we expect headline prices to post it first monthly decline since May 2010, down 0.1% m/m, with the annual pace of consumer price inflation posting its 7th consecutive monthly drop, falling below the 2.0% mark with a drop to 1.9% y/y.

Core consumer price should rise in April, rising by 0.2% m/m pace (up 0.15% m/m at 2 decimal places), with the annual pace of core CPI inflation easing to 2.2% y/y. Looking ahead, with energy prices continuing to abate meaningfully, we expect the downward trajectory in headline consumer price inflation to remain largely intact, though core consumer price inflation should remain firm.

Release Date: June 15, 2012April Result: Industrial Production 1.1% M/M; Capacity Utilization 79.2%TD Forecast: Industrial Production 0.1% M/M; Capacity Utilization 79.3%Consensus: Industrial Production 0.1% M/M; Capacity Utilization 79.2%

Lower energy prices will be the key driver for narrowing the trade deficit in April, with the weakness in crude oil prices pushing the petroleum import bill lower. During the month we expect the trade deficit to narrow, falling to $49.0B from $51.8B the month before. We expect exports to fall for the first time since November with a 0.5% m/m drop, reflecting weakening global demand. Imports should also fall during the month, posting a 0.7% m/m decline, which would more than offset the weakness in exports. In real terms, the narrowing of the deficit should be more modest, with the external sector remaining a drag on economic activity during the quarter. With global activity appearing to have weakened dramatically and oil prices continuing to trade well below the $100/barrel mark, the improvement in the deficit should be sustained in the coming months, though the appreciation of the dollar should blunt some of the support from falling energy prices.

Release Date: June 15, 2012March Result: 1.9% M/MTD Forecast: 1.6% M/MConsensus: n/a

Manufacturing sales for the month of April are forecast to rise quite firmly for a second consecutive month by 1.6% M/M. This forecast is supported by manufacturing surveys which suggest a strong increase in activity during the month, the pipeline of orders in recent months as well as the firm gain in auto exports. On the flip side, weakness in commodity prices - as measured with the Bank of Canada's Commodity Price Index - during the month could skew the balance of risk to the forecast to the downside. Nonetheless, we would expect to see volumes to print firmly and should bode well for the monthly industry GDP print.

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