Bank Sees End to Interest Rate Increases

TD Bank predicts central banks in Canada and the United States will reverse course and begin reducing interest rates by the end of 2006.

In its latest economic forecast, TD says the Bank of Canada is likely to raise rates one more time, to four per cent, while the U.S. Fed will raise rates to 4.75 per cent. But TD says the most likely economic scenario is for a mild and short-lived slowdown in the U.S. that will spill over into Canada, "sending both central banks back into interest rate cutting mode by the end of this year."

"Last summer, we noted that housing market strength and household indebtedness in the U.S. was simply unsustainable, and that it would give way to an economic slowdown in the second half of 2006. Evidence is mounting in support of this view," says TD chief economist Don Drummond.

The predicted U.S. slowdown will be a drag on Canada's economic growth, although we should do better than the U.S. The U.S. economic expansion will ease to an average annualized pace of around 2.3 per cent in the second half of 2006 and first half of 2007, while Canadian economic growth will only marginally slip below its long-term trend rate of 2.8 per cent.

"Virtually everything that matters in our forecast flows from two key assumptions: first, the U.S. experiences an economic slowdown; second, the economic weakness proves to be mild and relatively short-lived," Mr. Drummond noted.

Mr. Drummond says there's a 30-per-cent chance the U.S. economy "will plow through its vulnerabilities" and expand at a 3.5 per cent annual rate, similar to the performance in recent years. This would provide support for major trading partners, especially Canada. But Mr. Drummond says there is an equal 30 per cent probability that the U.S. economic weakness will be longer and deeper.

The greatest risk, according to TD, is a "hard landing" for the American housing market, which would tip the U.S. economy into recession.

"The Canadian economy looks to be fundamentally healthy, but befitting of our status as a relatively small, open economy, the driving force over the next year or so will be from developments abroad," Mr. Drummond concluded.