INTEREST RATES: Rate speculation eases

Retailers chopped prices for clothing, furniture and appliances at a record pace in December in a battle to lure cautious consumers in the key Christmas period, data showed yesterday -- reinforcing the view that inflation poses no threat and the Bank of Canada could hold off longer than expected on rate hikes.

That helped send the Canadian dollar into a tailspin, as it posted its sharpest decline in three months. Also weighing down on the currency was news that Chinese authorities had instructed certain of its banks to curb lending because they failed to meet capital requirements. Traders sold the loonie on worries that the red-hot Chinese economy could slow, and hence dampen expansion in commodity-rich Canada.

But the shocker for markets was Canadian consumer price data for December, which showed inflation was much softer than analysts' expected. The Bank of Canada sets its key policy rate to achieve inflation of 2%.

Headline inflation dropped 0.3% month over month, while the year-over-year rate stands at 1.3% -- a big swing from negative readings in September but below the expected 1.6% rate. Meanwhile, core inflation, which removes volatile-priced items such as energy, also fell 0.3% in the month, leaving the year-over-year rate unchanged from November at 1.5%.

Six of the eight broad consumer-price categories measured by Statistics Canada were either flat or down in December.

"Inflation is subdued with a capital 'S,'" said David Rosenberg, chief economist at asset manager Gluskin Sheff + Associates of Toronto. "These are hardly [inflation] rates that will cause the Bank of Canada to tighten policy prematurely."

Driving prices lower was a bid by retailers to lure weary consumers to spend. Prices for clothes, furniture and appliances sustained their biggest single-month drop on record, said Douglas Porter, deputy chief economist at BMO Capital Markets.

"This says more of the competition among retailers than anything else," he said, adding prices have mostly dropped on discretionary goods, which are the type consumers delay buying in hard economic times.

Sales volumes have returned to pre-recession levels, but Mr. Porter said the rate of sales growth "is not blowing the door down" as in previous recoveries. Retail sales are expected to advance between 2.5% and 3% in the fourth quarter, which would be down from the 3.1% gain recorded in the preceding three-month period.

In its interest-rate statement on Tuesday, the Bank of Canada acknowledged core inflation was ahead of expectations. Nevertheless, it indicated it was comfortable with keeping its key rate at a record-low 0.25% until at least July, which it has conditionally pledged to do, as a result of "persistent strength" in the Canadian dollar, which makes imports cheaper; weak U.S. demand; and the large amount of economic slack, which includes unused industrial capacity and relatively high levels of unemployment.

The central bank is scheduled to expand on its rate statement and economic outlook with the release of its quarterly monetary policy report today.

Mr. Rosenberg told clients in a note yesterday he reckons the Bank of Canada would not begin raising its target rate until mid-2011 "at the earliest."

He said historically the central bank has resisted tightening until the economic slack is nearly absorbed and the unemployment rate drops 150 basis points from its peak. (That peak -- 8.7% -- was set last August. The jobless rate is now 8.5%.)

"Unless the bank wants to be pre-emptive, which is highly unlikely when it acknowledges that 'the recovery continues to depend on exceptional monetary and fiscal stimulus' ... then to go and raise rates before the middle part of 2011 would be totally inconsistent with its own forecast as it stands right now," Mr. Rosenberg said.

(prepared by Paul Vieira/Financial Post/National Post)