The combination of a deteriorating outlook for the US economy, falling commodity prices and persistent financial market volatility are boosting the downside risks to Canada's economic outlook and will likely see the Bank of Canada lower the policy rate by 50 basis points at next week's meeting. Despite a concerted effort by global central banks and governments to ease market concerns about counterparty risk and shore up investor confidence, financial markets continue to flail with equity markets unable to sustain gains. Wholesale funding costs have started to ease but remain elevated meaning that the cost of capital for businesses and households is staying high and availability limited.

A rate cut next week would follow up on the 50 basis points ease announced by the Bank on October 8 when the Bank joined several other central banks in a coordinated policy move. The Bank of Canada highlighted the significant tightening in credit conditions, weakening demand for Canadian exports and more moderate growth in domestic demand in the October 8 press release and said that "this action will provide timely and significant support to the Canadian economy." Given the steady decline in commodity prices since October 8, inability of equity markets to sustain an improved tone and increasingly weak US data reports, we think it is likely that the Bank will choose to act aggressively next week and cut the policy rate to 2%. Additionally, Friday's reports showing that business lending conditions tightened further in September according to both senior loan officers and Canadian businesses will give the Bank incentive to supplement its already-stimulative monetary policy stance. Should the Bank decide to hold the policy rate steady or cut by a smaller 25 basis point increment next week, we would look for a cut at the December meeting meaning that the overnight rate would still end 2008 at 2%.

Our assessment remains that growth in Canada will be stronger than the US in 2009 although the pace will be slower than the economy's potential. The support for the domestic economy coming from the terms of trade will lessen going forward on lower commodity prices and the recession in the US will trim demand for Canadian exports. Our view that the significant tightening in credit conditions will begin to ease in the months ahead will go some distance to shoring up consumer and business confidence and prevent the economy from slipping into a recession. However, the risk that spreads remain wide and lending standards tight cannot be discounted and supports the case for the Bank to move aggressively in the near term and then hold the policy rate at 2% for several quarters. Our forecast that the economy will return to a firmer growth path in the second half of 2009 suggests that the Bank will be in a position to make a small step toward removing some of this stimulus in the final quarter of next year and raise the overnight rate to 2.25%.

Fed to lower policy rate to 1% and retain easing bias
We still expect the Fed to lower the Funds rate by another 50 basis points before the year's out with the odds favouring the move at the October 29 meeting. Economic data have been weaker-than-expected and risk a sharper downturn in Q3 and Q4 than in our baseline forecast. More worrying is the lack of traction in financial markets from the spate of policy actions with equity markets still preparing for the worst while the 3-month Libor rate is lower but remains relatively elevated. Yesterday's Beige Book provided no sign that any region of the US economy is seeing an improvement in conditions.

While we believe the aggressive policy actions will eventually boost investor and consumer confidence and allay uncertainty in financial markets thereby reducing the cost of funds for financial institutions and ultimately credit spreads, the Fed will continue to keep the financial system flush with cash and interest rates extremely accommodative until a decisive turn is evident. This is unlikely to occur quickly and we maintain the view that the economy will only start to revive in late 2009. As long as the downside risks to economic growth remain paramount, the Fed will maintain a bias toward additional monetary policy stimulus which means that they may feel the need to continue easing in 2009 as a supplement to liquidity injections and targeted market operations. Our consensus view is that the 1% funds rate plus narrowing credit spreads will be sufficient to avoid a protracted economic recession although given the depth of the negative sentiment, we cannot rule out additional interest rate cuts. We expect the Fed to hold the policy rate at 1% throughout 2009 and forecast only a modest increase in term rates over the year ahead. This is a change from our previous forecast that the Fed would be in a position to increase the policy rate before the end of next year.

US Housing Starts continue to fall
Housing starts in the United States fell at a 6.3% m/m annualized rate to 817,000 units in September, as the prior month's figure was revised down to 872,000 from the initially reported 895,000. Permits fell to 786,000 following August's fall to 857,000. The market was looking for 872,000 starts and 840,000 permits.

The 6.3% m/m fall in housing starts suggested the market has yet to bottom. Though weak, starts have yet to reach the low of 798,000 of the last US housing downturn in the early 1990s. The weakness was concentrated in the northeast (-20.9%) and West (-16.8%) with the rise in multiples (from 254,000 to 273,000) failing to offset the fall in singles (from 618,000 to 544,000). Permits, however, are now at their lowest level since November 1981.

If a silver lining is to be found, it lies in the fact that the further and lower starts fall, the faster excess inventory will be worked off. Only once inventories of unsold homes retreat back to historical norms do we expect prices to stabilize and a steady recovery to take hold.

In the near term, the report points to continued weak growth in the residential investment portion of GDP in the months ahead. Combined with a downturn in other areas of the US economy, the report is yet another confirmation that the US economy is on a downward trajectory. In response, we expect the Fed to cut the Fed funds rate by 50 bps bringing it to 1% by the end of this year.