FULL TEXT-Bank of Canada Monetary Policy Report

OTTAWA Oct 23 (Reuters) - The Bank of Canada released the following Monetary Policy Report on Thursday:

OVERVIEW

Three major interrelated global developments are having a profound impact on the Canadian economy and making the outlook more uncertain than it was at the time of the July Monetary Policy Report Update. First and foremost, the intensification of the global financial crisis in recent weeks has been reflected in severe strains in global money and credit markets and sharp falls and extreme volatility in global equity markets. The associated need for the global banking sector to continue to reduce leverage will restrain growth for some time. Second, there is growing evidence that the global economy is heading into a mild recession, led by a U.S. economy that is already in recession and expected to pick up only modestly through 2009. Third, there have been sharp declines in the prices of many commodities since the July Update. These developments have reduced inflationary pressures globally. In response to the global financial crisis, policy-makers in major economies have taken several extraordinary actions to provide liquidity to markets, recapitalize their banking sectors, and restore credit flows. In line with the G7 Plan of Action, these initiatives have reduced the risk of a significantly worse outcome for the global financial system, and Canada's economy and strong financial system will benefit directly. Nonetheless, the deleveraging of the global financial system will take some time to complete, and will involve a larger and more persistent tightening of credit conditions than was assumed in July.

Given these developments, the projection for the Canadian economy has been revised down considerably for 2008 and 2009. However, uncertainty around the Bank's base-case projection for growth and inflation in Canada is much greater than normal, given the unsettled conditions in global financial markets and the rapid deceleration of global growth. The weaker outlook for global demand will increase the drag on the Canadian economy coming from exports. Lower commodity prices will also dampen the outlook, working through a deterioration in Canada's terms of trade to moderate domestic demand growth. The marked tightening in Canadian credit conditions in recent weeks will restrain business and housing investment. As a result, economic activity in Canada is projected to remain sluggish through the first quarter of next year, then to pick up over the rest of 2009 and to accelerate to above-potential growth in 2010, supported by improving credit conditions, the lagged effects of monetary policy actions, and stronger global growth. The recent sizeable depreciation of the Canadian dollar will also provide an important offset to the effects of weaker global demand and lower commodity prices. Overall, the Bank projects average annual growth in real GDP of 0.6 per cent in 2008 and 2009, rising to 3.4 per cent in 2010.

The growth of potential output has been slower than previously anticipated, owing to anemic productivity growth that has been only partially offset by a larger-than-expected increase in the supply of labour. The Bank has lowered its estimate for the growth of potential output to 2.3 per cent in 2008, and assumes a gradual rise to 2.5 per cent by 2010. The Canadian economy is judged to have moved into slight excess supply in the third quarter of 2008. This excess supply is expected to build through to the end of 2009, and is not projected to be fully eliminated until the start of 2011. With growing slack in the economy, and a lower assumed path for commodity prices, inflation pressures in Canada are projected to ease significantly relative to the July Update. Core inflation is projected to remain below 2 per cent until the end of 2010. Assuming oil prices in a range of US$81 to US$88 per barrel, consistent with recent futures prices, total CPI inflation should peak in the third quarter of 2008, and is projected to fall below 1 per cent in mid-2009 before returning to the 2 per cent target by the end of 2010.

In October, the Bank lowered its policy rate by 75 basis points and said that, in line with the new outlook, some further monetary stimulus will likely be required to achieve the 2 per cent inflation target over the medium term. In light of diminished inflationary pressures, the Bank of Canada lowered its policy interest rate by 50 basis points on 8 October, acting in concert with other major central banks. This extraordinary action, together with a 25-basis-point reduction on 21 October, brings the cumulative reduction in the target for the overnight rate to 75 basis points since the Bank's last fixed announcement date. These actions provide timely and significant support to the Canadian economy. The cumulative reduction in the Bank's policy rate since the beginning of December 2007 is now 225 basis points. In line with the new outlook, some further monetary stimulus will likely be required to achieve the 2 per cent inflation target over the medium term.

The Bank judges that the risks are roughly balanced around its revised base-case projection for inflation in Canada-a base case that now incorporates the recent intensification of the global financial crisis, a mild global recession, and the measures that have been taken to resolve the crisis. The evolution of the financial crisis, its impact on the global economy, and the timing of the effect of the various extraordinary measures being taken to address it pose significant risks to the inflation projection on both the upside and the downside.