Recent pronouncements from the Bank of Canada and the federal finance department have led economic research firm, Global Insight Inc., to scale back its macroeconomic forecast for Canada.

“Canadian growth is predicted to be a little weaker than we thought last month, both this year and next, and interest rates are expected to be a little higher,” it says. “While the higher interest rates are a positive for the Canadian dollar, the reduced allure of income trusts to foreign investors provides an offset.”

Global Insight notes that the Bank of Canada lowered its short-term growth forecast for the Canadian economy on the back of a weaker projection for the US. The bank expects Canadian GDP to slow from 2.8% in 2006 to 2.5% in 2007, before rebounding to 2.8% in 2008. It adds that the bank also acknowledged that its prior view on Canada’s potential growth was too rosy. It scaled down its growth estimate from 2.9% for 2006 and 3% for 2007-08 to 2.8% for 2006-08.

“The bank’s revised view of potential growth, as well as some recent economic data, took the edge off the urgency to lower interest rates. Consequently, Global Insight no longer expects overnight rate cuts in December and in 2007,” it says. “The key lending rate is now forecasted to stay at 4.25% through the end of 2007. Market interest rates are also expected to be higher, which will dampen consumer spending and housing starts. Canada’s GDP growth is projected to slide from 2.8% in 2006 to 2.4% in 2007. We look for a bounce back to 2.8% in 2008.”

“The Bank of Canada has managed a rare feat of being dovish on growth without sounding worried about undershooting its inflation target. Financial markets are still pricing in a small chance of a rate cut next year. If our call for steady monetary policy comes to pass, those expectations will unwind. Assuming the Fed will ease policy next year, we figure the steady Bank of Canada will lift the dollar up by half a U.S. cent by late 2007,” it says.

As for the federal government’s unexpected plans to tax the distributions of income trusts, the firm says, “If implemented, the proposed taxation would directly lower the income received in tax-exempt registered savings plans by Canadians and the income received by foreigners.”

“Most of the time, one needs a magnifying glass to spot the impact of fiscal policy changes on the Canadian dollar. It was different this time, as the Canada-U.S. dollar exchange rate fell about 3/4 of a U.S. cent in overnight trading after the trust-tax announcement,” Global Insight says.

“Although this negative impact will likely persist for a while, it should wear off over time,” it predicts. “The tax measure reduces the attractiveness of Canadian trusts to foreign investors and, thus, lowers their demand for Canadian dollars. This will create an excess supply of dollars that the Bank of Canada will eliminate over time to prevent a decline in the overnight rate.”

“On net, we are slightly more pessimistic in the near term about the Canadian dollar than in October,” it concludes. “The fallout from the trust-tax proposal will depress the currency to below 88 U.S. cents by early 2007. A narrowing of the negative Canada-U.S. interest rate spreads, however, will move the loonie to just above 89 U.S. cents by the end of 2007, which is the same forecast as in October.”