The statement indicated that surprises since the April Monetary Policy Report have been largely on the side of inflation with the CPI now expected to move above, albeit temporarily, 4%. On the growth side developments have largely been in line with their views expressed in April. There seems to be little concern about the recent deterioration in financial markets with the Bank even indicating that they expect growth to move above potential by "early next year."

The Bank's statement focused on three main areas - "protracted weakness in the U.S. economy; ongoing turbulence in global financial markets; and sharp increases in many commodity prices." While the statement indicated that the first two factors are evolving in line with the Bank's forecasts, the unprecedented rise in commodity prices has raised the upside risks to inflation while keeping Canada's terms of trade improvement intact and supporting income growth. The Bank downgraded forecasts for growth in 2008 to 1.0% from 1.4% but was optimistic that the combination of accommodative monetary policy, the terms of trade boost and a "gradual " recovery in the US economy will see Canada's growth rate rise to above-potential early next year. 2009's growth forecast was forecast at 2.3% (small downward revision from April's 2.4%) with the economy expected to grow 3.3% in 2010.

More importantly, the Bank upped their forecasts for headline inflation and said that the rate will remain higher for longer than in the April forecast. The updated projection said that Canada's headline inflation rate may "rise temporarily above 4 per cent, peaking in the first quarter of 2009" if the energy prices follow pricing in the current forward curves. The core measure however "is projected to remain well contained and broadly in line with earlier expectations, averaging close to 1.5 per cent through the third quarter of this year and then rising to 2 per cent in the second half of 2009." The forecast for the second half of 2009 was revised up from April's 1.8%.

Based on these forecast updates, the Bank now gauges the risks to the "base-case projection for inflation as balanced."

The Bank's upgrade to the inflation forecasts put some meat on the bones of their June statement that the "balance of risks to the Bank's April projection for inflation in Canada has shifted slightly to the upside" with the biggest surprise being that the Bank raised the prospect that the headline inflation rate could rise to 4% in the near term and will remain above target into next year. Despite the somewhat hotter inflation environment, forecasts that the economy will grow at a slower than potential rate this year (and we think that downside risks to the economy mounting given renewed financial market turbulence), suggests that the Bank is likely to hold the policy rate at 3%.

U.S. June retail sales weaker than expected

In June, US retail sales rose a minimal 0.1% compared to an expected increase of 0.4%. A large component of the weakness was attributable to the motor vehicle component where sales dropped 3.3%. Excluding this component, sales were up a more robust 0.8% and followed a 1.2% gain in May. However, the increase was slightly lower than the 1.0% expected within financial markets going into the release.

A solid increase in the ex-auto component was in part a reflection of higher prices for gasoline which helped send service station receipts up 4.6% in the month. However, solid increases also occurred in clothing (+0.6%) and health and personal care (+0.6%) stores that likely reflected more strength in volumes rather than prices. Providing some offset to these gains were disappointing declines in furniture (-1.4%) and electronics (-0.6%) stores. The latter reflected a partial retracement after a 2.3% surge in May. The component of retail spending that directly enters into the GDP addup for consumption, retail sales excluding automotive and building materials and garden supplies, rose a solid 1.0% and represented little slowing from the 1.1% achieved in May.

In a separate report, June producer prices index (PPI) rose a stronger-than-expected 1.8% though this largely reflected a 6.0% surge in energy prices. Excluding this component along with food prices, the core PPI rose only 0.2% slightly under an expected 0.3% monthly rise.

The retail sales numbers, though slightly weaker than expected by financial markets, are indicative of Q2 consumer spending growth of slightly under 2%. It may be the case that the impact from the fiscal stimulus is occurring more quickly than assumed and thus may have just borrowed strength in consumer spending from the expected 4% gain that we had projected for Q3. As well, despite the near-term buoyancy, the impact from the tax rebates is expected to be short-lived and not likely to extend beyond the current quarter. As a result, the recent deterioration in financial markets, and attendant credit tightening, suggests the re-emergence of a downside risk to growth in the final quarter of this year and going into 2009. Bernanke's testimony later this morning will be monitored to see whether the Fed shares these concerns about the risks to growth that have recently been overshadowed by inflationary concerns prompted by rising energy and food prices.