Pressure grows for interest rate cuts soon

From cars to cantaloupes, the surge in the Canadian dollar is beginning to put significant downward pressure on consumer prices, leading economists to forecast the Bank of Canada could start cutting interest rates as early as December.

Statistics Canada reported yesterday Canada's annual inflation rate fell to 2.4% in October from 2.5% in September. The Bank of Canada's core rate, which excludes volatile items such as gasoline, fell to 1.8% from 2.0%. That was the smallest increase since June, 2006, and finally puts it below the bank's 2.0% target.

"We now call for the Bank of Canada to cut the overnight rate by 25 basis points on Dec. 4, and again on Jan. 22," Don Drummond, chief economist at Toronto-Dominion Bank, said in a forecast change. "The Canadian dollar is exerting a greater drag than the Bank of Canada had expected, and Canadian inflation continues to trend persistently lower."

Avery Shenfeld, senior economist at CIBC World Markets, said the clearest evidence that the loonie is pushing down consumer prices is in the huge gap that has opened up between Canadian and U.S. inflation rates. U.S. headline inflation is now running at 3.5% compared with Canada's 2.5%, despite the fact Canadian housing prices are still rising strongly.

"For those who doubt a strong Canadian dollar has no impact on Canadian retail prices you only have to look at these numbers to make the case otherwise," he said.

The loonie had its fingerprints all over the report.

StatsCan said lower prices for autos were the main factor behind the drop in the core rate.

Leasing prices fell 2.3% on the year and car purchase prices fell 2.5%. Prices for fresh vegetables tumbled 14.6% in October from a year ago, the biggest drop since June, 1996, and following a 9.2% drop in September.

Photo equipment was down 8%, home entertainment down 2.2%, children's wear off 2.2% and women's clothing 2.3%.

David Wolf, Canadian economist at Merrill Lynch, said retailers are now scrambling to slash prices to fend off a wave of cross-border shopping. Consumer outrage over the previous slow pace of declines also likely contributed to the drop of 0.3% in overall prices in the month.

"Overall we did see substantial drops in traded goods, which is as one would expect given what the Canadian dollar has done and the enormous price gap that has opened up between the prices of those same goods in Canada and the United States, which domestic retailers are scrambling to adjust to in the hopes of salvaging some customers," Mr. Wolf said.

Prices are likely to drop further with cash rebates now reaching up to $10,750 at some car dealers, an increase of up to $5,250 over October.

On the upside, housing is still pressuring inflation higher, with the cost of owned accommodation up 4.8% in October over the year largely due to a 6.7% rise in mortgage interest costs, the largest increase since June, 1991.

But analysts said the overall drop in both headline and core inflation would opens the door for a rate cut from the Bank of Canada.

Other analysts said the bank could switch to an easing bias in December with cuts beginning in 2008, depending on the data.

"An alternative scenario for the December meeting sees the BoC shifting from a balanced outlook to one that highlights the increase to the downside as Governor Dodge essentially indicated," said Stewart Hall, market strategist at HSBC Securities.

Mr. Shenfeld is not expecting the Bank of Canada to cut rates, however, noting the loonie has already come off its surge to a record $1.10.

"The currency seems to be dealing with its problem on its own," he said.

"It's come off quite a bit. The Bank of Canada might not have to cut rates to cool the currency."

The Canadian dollar ended yesterday at US$1.0147 up US0.42¢

(prepared by Jacqueline Thorpe/Financial Post)