Recent Developments: An Update to the Monetary Policy Report

Highlights The pace of economic activity in the United States remains strong, exceeding earlier expectations. With the stronger momentum of external demand, the Bank now expects Canada's real GDP growth in 2000 to be in the upper half of the 2.75 to 3.75 per cent range projected in the last Monetary Policy Report. Core inflation was below expectations in November, partly because of price discounting on certain semi-durables. The Bank expects core inflation to increase to 2 per cent in the first quarter of 2000. Because of higher energy prices, the rate of increase in total CPI is expected to rise to close to 3 per cent early in the year. Developments during the last threemonths underscore the risks to Canada's economic outlook highlighted in the last Report: stronger momentum of demand for Canadian output from both domestic and external sources and potential inflationary pressures in the United States. Information received since 14 January, when the update to our November Monetary Policy Report was completed, continues to point to a strengthening outlook for the world economy and for Canada. In the United States, real GDP again exceeded expectations-rising at an annual rate of 5.8 per cent in the fourth quarter. While some price and cost pressures are evident in the United States, strong productivity growth has thus far held unit labour costs down. Because of the rapid expansion of demand above the growth of potential capacity, however, and the associated inflation risks, the Federal Reserve increased its federal funds rate by 25 basis points to 5.75 per cent on 2 February. Although trend inflation remains low in the industrial countries, a number of other major central banks have also raised their policy rates in the last couple of weeks because of concern about future inflation pressures, given strengthening demand. The buoyancy of external demand, particularly that coming from the United States, continues to show in our latest merchandise trade numbers. Export growth in November remained strong, with the overall trade balance in large surplus. World prices for our key primary commodities also continue to firm in response to rising global demand. On the domestic side, the latest information on demand and production points to continued robustness. Real GDP (at factor cost) rose 0.6 per cent (4.6 per cent year-over-year) in November, and employment continued to grow strongly through year-end and into January. Other indicators, including the latest data on the monetary aggregates, support this strong economic picture. The Bank now expects real GDP growth in 2000 to be near the top of the 2.75 to 3.75 per cent range projected in November. Our core measure of inflation was 1.6 per cent (year-over-year) in December, slightly below expectations, partly because of temporary discounts on certain items. Core inflation is still expected to move up to the midpoint of the Bank's 1 to 3 per cent target range in the first quarter. Over the same period, the total CPI will likely rise to close to 3 per cent because of the recent sharp step-up in energy prices but is still expected to come down towards the core rate during the course of 2000 as energy prices moderate. The Bank of Canada raised its Bank Rate by 25 basis points to 5.25 per cent on 3 February. The factors behind this decision included the strong momentum of demand in Canada from both external and domestic sources, the importance of approaching full capacity in a prudent way, and the risk of a spillover of potential inflation pressures from the United States.