The Canadian economy may have started to turn the corner on the recession in July, but now comes the hard part. Although it was fairly easy to train the fiscal and monetary policy guns on a severe slowdown, managing the recovery looks to be considerably trickier.

In the Bank of Canada’s latest Monetary Policy Report, released on July 23, the central bank has effectively called an end to the recession, saying that it expects to see economic growth revive in the current quarter. The previous version of the MPR didn’t foresee the recovery starting until the fourth quarter of 2009.

Instead, the BoC finds that financial conditions have been better than expected, and both business and consumer confidence have also been more robust than anticipated. As a result, the downturn hasn’t been as deep as expected, and the recovery is coming in a bit earlier than predicted.

The BoC now sees quarter-over-quarter GDP growth of 1.3% in the third quarter, compared with its previous call of a 1% decline. The BoC has similarly upgraded its quarterly and annualized GDP forecasts through the first half of 2010.

This new forecast is “now again markedly more optimistic than the consensus,” notes a research report by analysts in Bank of Montreal’s capital markets division. The BMO report adds that the consensus call for Canadian GDP growth in 2010 is closer to 2%.

Moreover, as the BMO report points out, this renewed sense of optimism in the BoC’s forecast “stands in stark contrast to flatly cautious public comments by the bank in recent weeks, where [BoC] governor ]Mark] Carney seemed to be trying to manage down expectations.”

Not only does the BoC seem to have a pretty rosy view of the impending recovery, but it also has a sanguine take on inflation. Reflecting the BoC’s more bullish view on the economy, it also raised its core inflation predictions in the MPR right through to 2011. However, the BoC still expects to see core inflation decline over the next couple of quarters before resuming its march toward the BoC’s target of 2% by mid-2011.

Moreover, the MPR suggests that the overall risks to the inflation outlook are “tilted slightly to the downside.”

The primary downside risks the BoC sees to inflation are a faltering global recovery that could undermine trade and confidence in Canada, and a stronger loonie, which could also serve as a drag on economic growth.

With so much slack in the economy, it’s hard to imagine that the BoC will have to concern itself with inflation anytime soon. The current batch of economic data from Statistics Canada paint a fairly ugly picture of the Canadian economy: unemployment at 8.6%, up by 240 basis points over the past year; business investment down by almost 20%; exports down by 33%; housing starts off by 35%; and capacity utilization at less than 70%.

And, in fact, the latest consumer price index shows a 0.3% drop, compared with the previous year, which has sparked some concern that deflation could be on the way.

However, core CPI was up by 1.9% over the period, highlighting the fact that the energy component (which, among other very volatile components, is excluded from core CPI) is the real driver behind the index’s decline.

The opposite concern, then, is the puzzling resilience of core inflation amid the recession. Economists at Toronto-Dominion Bank suggest in a recent report that a variety of factors have been supporting consumer prices in recent months. Food prices have been rising in response to more expensive inputs, such as feed and fertilizer; import prices are up because of a weaker loonie. The TD report also points out that the prices charged for services tend to hold up better in recessions than prices for goods.

The TD report sees some of those factors abating in the months ahead. As a result, TD expects core inflation to slip back below 1% by mid-2010, then converge with headline inflation at around 0.7% in the middle of next year. Core inflation will then climb back toward the BoC’s 2% target by the end of 2012, the TD report predicts. This is notably lower than the BoC’s forecast, which sees core inflation bottoming out at 1.4% in the fourth quarter of this year and the first quarter of 2010, and returning to the target level in mid-2011.

@page_break@The divergence between these forecasts is largely based on TD’s expectation that the economy will experience a rather slow recovery. The TD report foresees a modestly deeper contraction than does the BoC this year: “…but, more important, a much slower recovery next year, implying a greater and longer lasting output gap.”

A weak recovery means that excess capacity would take a long time to work out of the economy. “The lingering output gap will constrain, or outright reduce, the pricing power of firms and diminish input costs,” the TD report suggests.

Additionally, many firms have relatively high inventories, meaning they “will have an incentive to provide additional price discounting to draw in buyers and work down their stocks,” the TD report continues. TD also expects that the effects of the recession will finally work their way through to service prices, and that a weaker U.S. dollar/stronger loonie will also spell lower import prices.

Finally, the TD report notes that the harmonization of sales taxes in Ontario will lead to lower producer prices that should feed through to consumer prices, possibly reducing core CPI by as much as 30 bps.

If the TD report is right, inflation will remain well contained, but economic recovery will be painfully slow. If the BoC is right, and growth is relatively robust, then higher inflation becomes a concern.

In the MPR, the BoC says that there are significant upside risks to the inflation outlook — mainly domestic factors, such as an even more robust recovery. But the BoC also flags another, less appealing, possible source of inflation that has been largely overlooked: “The possibility that potential output will be lower … if the extensive restructuring in certain sectors is more protracted and the investment response is more delayed than currently envisaged.”

The BoC has already lowered its estimate of potential output for the 2009 to 2011 period in the April edition of the MPR. And in the current report, the BoC trims the estimate for 2009 by just 10 bps to 1.1%, while leaving its calls for 2010 and 2011 at 1.5% and 1.9%, respectively. (It also has revised the 2008 number down to 1.7% from 2.0%).

This is a long way down from last October’s MPR, when the BoC saw potential output for 2009 growing at 2.4%, and at 2.5% in the next two years. (The BoC indicates that it will provide a more comprehensive review of its estimates for potential output growth in the upcoming October MPR.)

If Canada’s economic growth potential remains rather constrained but demand continues to build, there’s the risk of higher inflation, which would create a real policy dilemma for the BoC. It has committed to keeping interest rates at rock-bottom levels through the second half of next year; but, if inflation starts to perk up, the central bank will have a fine line to walk between controlling that inflation and possibly undermining what’s expected to be a fragile recovery with tighter monetary policy.

Another tricky issue for the BoC remains the value of the Canadian dollar. As a CIBC World Markets Inc. research report points out, the US92¢ loonie is a full US5¢ higher than the US87¢ assumed by the BoC in its forecasts. If the C$ persists at this level — and since the BoC has no room to fight its rise with lower interest rates — the CIBC report estimates that this could chop as much as a percentage point from the BoC’s GDP forecast.

“That’s not fatal if Carney’s base case projection was right,” the CIBC report suggests. “But if his view was already a tad too high, chopping another point could see the expansion run too slow to make much progress on the jobless rate next year.”

There are lots of ifs and buts in any economic forecast, but the current outlook seems to have more than its fair share of uncertainty and potential policy dilemmas. The recession may be history, but the recovery still looks particularly dicey. IE