The Canadian Press - ONLINE EDITION

Bank of Canada caught between optimism for future and today's harsh reality

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OTTAWA - By almost universal agreement the Bank of Canada is expected to hold tight Wednesday and keep its stimulative policy interest rate at one per cent for the umpteenth time, but the central bank faces a dilemma.

Most of the good news on the economy is in some theoretical future and most of the bad news is happening now.

If things don't pick up soon, what the central bank might want to consider is something few thought feasible a few months ago or even a year ago - cutting interest rates, says David Madani, economist with Capital Economics in Toronto.

That is not Madani's base-line scenario, he wants to make clear. But he also doesn't rule it out.

"If there is going to be a change in interest rates, I think it's more likely it will be a cut than an increase," he says.

Madani, who is known to be bearish on the economy, sees no reason to change his mind. "Where is this growth going to come from if exports continue to (be weak) and business investment remains fairly cautious and housing is acting as a drag on the economy? That's why the Bank of Canada might have to think about supporting the economy a little bit."

The bleak viewpoint is supported by data that suggests the brutal winter can't be blamed for all that's ailing the economies of the United States and Canada.

Last week, the U.S. estimated its economy pulled back in the first quarter, a startling contraction more than three years into a recovery period. By the reckoning of some, the winter might have sliced about 1.5 percentage points off growth, which would still have left the first quarter barely above zero.

In Canada, gross domestic product growth was a bit stronger at a pace of 1.2 per cent, but still well south of the speed the central bank believes is necessary to close the capacity gap.

Jobs growth has been stagnant for months and, on Monday, the RBC manufacturing purchasing manager's index showed better weather hasn't warmed the factory sector as the index dropped for the second consecutive month to 52.2 in May, the lowest setting since January.

The manufacturing index in the U.S. did show some improvement, after being misreported twice by the Institute of Supply Management, although the employment index dipped somewhat.

TD Bank chief economist Craig Alexander says the growth story the central bank has telling for months remains the most likely, although he concedes it would be more convincing if current trends supported the "don't worry/be happy" narrative.

Even so, he says, the bank is "between a rock and a hard place" dealing with an economy that always appears poised to shift into a higher gear but never does. With household debt near record levels — 164 per cent of annual disposable income — and housing prices setting records almost monthly, the bar for cutting interest rates is high.

"If you didn't have the personal leverage problem ... we'd actually be having a much bigger debate about the probability of cutting rates," he explained.

"But I also think the Bank of Canada still believes, and I think correctly, that the weakness we're seeing today is overstated and that conditions should improve."

Still, Alexander expects the central bank will sound dovish on the economy Wednesday, acknowledging that inflation has been stronger than expected, but the economy — which at this stage of the recovery is more key — has been weaker.

Markets appeared to agree with that view on Monday, dropping the Canadian dollar about half a point to below 92 cents US in advance of the bank decision.

Alexander said TD's official forecast is for the central bank to start hiking interest rates at measured increments starting in mid-2015, but cautioned that the odds of rate hikes being delayed further are growing.

Note to readers: This is a corrected story. An earlier version used incorrect information supplied by the Institute of Supply Management.

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