Interest rate forecast detail table

 

 

RBC interest rate forecast update

June 26, 2008

 

The Fed and the Bank of Canada became more vocal regarding their concerns about the inflation outlook in the past month and kept policy rates at 2% and 3%, respectively, at their June meetings. The increased focus on inflation against a backdrop of slow economic growth sets up for both banks to continue to hold the policy rates steady as policymakers gauge the impact of the elevated level of energy prices on prices and output.

 

United States - We are forecasting that the Fed will hold the funds rate at 2% for the remainder of 2008 as the U.S. economy works through the persistent contraction in the housing market, high energy prices and financial market stresses. Growth is expected to firm in the third quarter aided by the healthy dose of fiscal stimulus but to slow in the final quarter of the year as the impact of the stimulus fades.

 

We have updated our inflation forecasts to take into account the high level of crude oil and gasoline prices and now look for the headline inflation rate to hold above 4% until late this year when we assume that energy prices will be lower than today's elevated level. This combination of modest growth and high inflation will likely see the Fed hold the policy rate steady at 2% (rather than cut the funds rate to 1.75% as we had expected in our June forecast) as policymakers monitor whether or not the growing economic slack will work to contain inflation expectations and wages.

 

In the near term, two-year yields are likely to bounce around in a 2.75% to 3% range and to trade at the lower end of that range at year-end as the combination of easing inflation pressures and modest growth pushes out expectations of a Fed rate hike. Ten-year rates are forecast to grind higher, trading from today's 4.10% to 4.5% by year-end on the back of the persistently elevated level of headline inflation. As the economy builds momentum in 2009, the Fed is expected to begin the process of shifting the policy rate from its accommodative stance toward neutral. The fragile economic landscape means that this process will be slow and deliberate, with the Funds rate expected to end 2009 at 2.75%, two-year rates at 3.5% and the 10-year bond yield at 4.55%.

 

Canada - The Bank of Canada, like the Fed, is likely to remain sidelined for the rest of the year and is wary about the impact of the elevated level of energy prices on CPI inflation. In the statement accompanying the June 10 rate announcement, the Bank showed heightened concern about the inflation outlook stating that if the recent spurt in energy prices persists "total CPI inflation will rise above 3 per cent later this year."  Still, the Bank expects the core inflation rate to remain below 2% through 2009 as the excess capacity in the economy continues to grow.

We have updated our Canadian inflation forecasts to account for the high level of crude oil and gasoline prices and now look for the headline inflation rate to rise to the high end of the Bank's 1% to 3% target band and remain there until late in the year.

Our forecast for growth is little changed with Canada's economy expected to recover from the modest contraction in real GDP in the first quarter, although the annual growth rate will be relatively moderate compared to the robust pace of previous years. On balance, we look for the amount of spare capacity to grow in 2008, thus mitigating some of the upward pressure on prices and keeping the core inflation rate below the mid-point of the target band for most of the year. With the overnight rate at 3%, two-year rates are forecast to end 2008 at 3.6% (from 3.2% today) with the yield on the 10-year bond at 4%, about 30 basis points higher than the current level.  

As the economy's growth momentum builds in 2009 and downside risks to the US economy and financial system moderate, the Bank is expected to start to shift policy to a less accommodative stance, with a rate hike likely in the first quarter to 3.25%. Like the Fed, the process to normalize rates will be slow and we look for only one more 25 basis-point increase in 2009, with the overnight rate finishing the year at 3.5%, two-year yields at 3.8% and the 10-year rate at 4.4%.

ECB -The ECB is forecast to raise the policy rate to 4.25% in early July to contain the pass-through from the rise in the inflation rate into inflation expectations and ultimately into wage gains. Evidence of a downshift in growth continues to accumulate, meaning that this fine-tuning adjustment to the policy rate will probably be a one-off event. The prospect of slower Eurozone growth in 2009 will lead to a reversal of this move early next year, with the official rate expected to be cut back to 4% in the first quarter of 2009 with one more ease to follow in the second quarter.

Bank of England - The Bank of England is facing more intense cross-currents than most other central banks - slowing growth but elevated inflation - but we expect that it will follow the same policy prescription in the near-term and hold the policy rate steady. Later in the year, a steady slowing in the pace of economic growth and some relief on the inflation front will likely see an easing in the policy rate with one 25 basis-point cut expected in November followed up with a full-fledged easing cycle in 2009.