TD Bank economists are calling for rate hikes in Canada as early as September, in the belief that the economy is strong. Yet, they warn that the second half of 2006 may herald weakening.

“The Canadian economy has been delivering a lacklustre performance since the fourth quarter of 2004, with real [gross domestic product] advancing at below a 3% annualized pace. However, this headline result masks considerable strength in the domestic economy, which has left the economy operating at close to full capacity and sets the stage for the Bank of Canada to begin raising interest rates, likely as early as on September 7,” it says in a new report.

TD notes that consumer spending has been rising at a solid pace, fuelled by low interest rates and favourable labour market conditions. High levels of corporate profits, elevated rates of capacity usage and the need to increase international competitiveness have all been a powerful catalyst to business investment, with outlays on machinery and equipment rising at a double digit pace. Residential construction has also been strong. “Consequently, while overall real GDP has increased at a moderate pace, domestic demand has been booming, increasing by an annualized 4.4% in the final three months of 2004 and by 6.3% in the first three months of 2005,” it says.

The main factor holding back the economy has been weakness in the manufacturing sector, largely brought about by the lagged fallout from the past appreciation in the Canadian dollar, TD notes. But, it says, “As the effects of the currency shock wanes and amid strong economic growth south of the border, we look for the Canadian economy to improve, with economic growth picking up to above the 3% mark in late 2005 and early 2006.”

“This firming in economic growth, especially among larger businesses, augurs for a gradual rebalancing in monetary policy,” it adds. Markets expect a 25 basis points rate hike at the September 7 Bank of Canada meeting. “Regardless of the precise timing, the Bank will surely take a gradualist approach to tightening monetary policy, and the improvement in economic conditions is expected to result in the overnight rate being lifted to 4.00% in early 2006,” it says. “This represents a significant 150 basis point increase in short-term rates, though it should be stressed that it still leaves rates, both in nominal and real terms, at historically low levels.”

However, it also warns that there are storm clouds on the horizon that make it less optimistic about prospects in the second half of next year. “It is evident that the U.S. economic expansion has considerable momentum, but it is also clear that a number of major economic imbalances have developed that are directly related to the sustained low interest rate environment experienced over the past couple of years,” it says, citing a housing market that “looks decidedly frothy”.

And, it notes that “there is a distinct possibility that economic growth may slow next year under the weight of tighter monetary policy, record consumer debt loads, a tapering off in mortgage refinancing activity, an absence of new fiscal stimulus and only modest growth in global demand for U.S. exports.”

“If the U.S. economy does experience slower growth, it will present a new challenge for Canadian exporters. At the same time, the pace of domestic demand growth in Canada may be constrained by a tighter stance to monetary policy by the Bank of Canada, which is expected to dampen interest rate sensitive areas of the economy, such as consumer durables and residential construction,” TD says. “The implication is that the Canadian economy may strengthen over the next 6 to 9 months, but the acceleration could prove short-lived, with real GDP growth slowing once again to below 3% in the second half of calendar year 2006. And, this time the domestic economy will simultaneously shift down a gear.”

“It should be stressed that we are not expecting a major economic slowdown or a major correction in Canadian housing markets. Indeed, the economy is expected to grow at slightly below a 3% pace for the third consecutive year in 2006. However, it does imply that the peak in interest rates is likely to be at relatively low levels and could occur in early 2006,” it concludes.

@page_break@This overall economic and financial outlook has significant implications for the small business sector, TD says. It says hiring trends suggest that larger businesses may outperform small businesses in the coming months. “Small businesses may be less vulnerable to a slowdown Stateside given their lower export exposure, but small manufacturing firms are still bound to be adversely affected to some degree. Meanwhile, a more moderate pace of consumer spending, a cooling in Canada’s housing markets and higher interest rates are likely to temper the prospects for many small businesses,” it cautions.

“Economic conditions are likely to be strongest in the West, where Alberta and B.C. are expected to lead in economic growth, while conditions in central Canada may be less supportive, reflecting the heavier exposure to non-commodity export-oriented industry,” it says.