Markets will be anxious this week to hear what Bank of Canada governor Mark Carney has to say about an economic metric that triggers excitement and debate among policy wonks: the output gap.

The output gap measures how much spare capacity, or slack, there is in an economy. That gap widened considerably after the global financial crisis when demand from the United States and elsewhere dropped off the proverbial cliff. The central bank has repeatedly said “considerable slack” remains in the Canadian economy, which kept firms’ pricing power in check and justified keeping its benchmark rate at 1%.

But recent data, including the central bank’s own survey of business leaders, indicate slack is disappearing at a faster clip than previously believed as the economy exceeds expectations. If that’s the case, inflationary pressure isn’t far behind, and theory dictates the central bank would like to get its policy rate to a so-called neutral level by the time all the slack dissipates.

The shrinking gap may just be the factor that prompts Mr. Carney to deliver a more upbeat assessment on the economy and, perhaps, telegraph interest rate hikes down the road.

Nobody, however, believes the governor will follow his European Central Bank peer and pull the trigger on Tuesday when the central bank’s rate decision is unveiled. The consensus among Bay Street investment dealers is that the first rate hike of 2011 will come in July, with a slim chance it happens in May.

But what Mr. Carney says this week about the output gap and when it will close “will be the most important thing markets will watch,” said Mark Chandler, head of fixed-income and currency strategy at RBC Capital Markets.

Futures markets have priced in two full rate hikes for the rest of 2011, but Mr. Chandler said that could change should the Bank of Canada signal slack would be absorbed well before its previous expectation, which was the end of 2012.

That late 2012 target date, however, was based on what now appears to be outdated economic outlook. The Bank of Canada previously anticipated a 2.3% annualized advance in the 2010 fourth quarter, and it turned out to be 3.3%; meanwhile, data to date point to 4%-plus growth for the January-to-March period, analysts say, compared with the 2.5% gain the central bank expected in January.

Michael Gregory, senior economist at BMO Capital Markets, said that based on economic indicators the output gap is roughly half as big as the central bank projected in its January forecast.

“To put this in perspective,” he said, “inserting the central bank’s now-stale January projection into the remainder of the forecast period results in the output gap closing by the end of this year, not the end of next year as initially projected.”

Even allowing for a downgrade in future quarters, he indicated the central bank could signal that slack will be fully absorbed no later than mid-2012, or six months ahead of schedule. As a result, Mr. Gregory added, “Carney and company are running out of economic room, not to mention time, in keeping policy rates at emergency low levels.”

The central bank, however, sets interest rates to achieve and maintain 2% inflation. With that in mind, the core rate — which strips out volatile-priced items such as food and energy — last month stood at a record low of 0.9%, which suggests firms still face challenges in raising prices to recoup increased energy costs.

Still, the central bank’s survey of business owners indicated inflation expectations have ramped up, surging to their highest level since mid-2008.

“Carney cannot ignore the risks of second round effects on wages and prices,” said Sébastien Lavoie, economist at Laurentian Bank Securities.

In fact, the jobs data released last week indicated average hourly wages in March advanced 2.7% year-over-year, the highest level in 19 months.

Prior to this week, Mr. Lavoie had said the first Bank of Canada rate hike of 2011 would occur in September. He now has moved up the timetable to possibly May or July.

“Carney has no choice but to send a more upbeat tone to financial markets,” he said. “He cannot take the risk of falling behind the inflation curve. Otherwise, he takes a huge risk of losing credibility.”

Article provided via The Financial Post

http://www.financialpost.com/news/economy/Mind+Markets+watching+what+Carney+says+about+shrinking+economic+slack/4591366/story.html

" For firms, new twist on strong Canadian dollar "..

" alot of exporters are forced to be basically like fortune tellers to try to figure out where the value of the loonie is going to be  in six to eight months time " ...

Many Canadian companies are feeling the pinch of a stronger dollar , sometimes in ways that are completely new.

For example, some manufacturers say they're being charged an extra 3 per cent to 4 per cent by Canadian suppliers if they pay in U.S. dollars, which are now worth less, said Craig McIntosh, chief executive officer of Acrylon Plastics in Winnipeg.

“There's American suppliers who we pay in U.S. funds. If they have Canadian operations, they're starting to charge us a surcharge to pay in U.S. funds,” he said. “That's new. They started this about three months ago.

“You like to have the convenience of buying locally, but when you start getting those surcharges we're ... moving away from Canadian suppliers who are doing this to us to buying directly from the United States,” he said.

With economists predicting the Canadian dollar could go as high as $1.09 (U.S.) by the end of next year, both manufacturers and consumers have some decisions to make.

Bruce Cran, president of the Consumers' Association of Canada, said Canadian prices haven't fallen much since the loonie first began its climb, which encourages Canadians to spend their money south of the border where prices are lower.

“Eighty per cent of us live by the border somewhere and our immediate solution is to just cross over and buy, which is very sad for retailers and sad for the country,” he said.

“I don't think consumers benefited from the two GST reductions, and we certainly haven't benefited much from the rise in the Canadian dollar.”

Anne Kothawala of the Retail Council of Canada said Canadian stores have to deal with high Canadian import taxes and that cross-border shopping takes money out of Canadian communities.

“(Shoppers) should continue to support Canadian retailers and continue to do all their shopping locally because ... they are supporting local economies,” she said.

The dollar's impact on exporters may have one of the biggest effects on Canada's economy and jobs.

Jeff Brownlee of Canadian Manufacturers and Exporters said that even though a few cents rise doesn't seem like a lot to most people, CME's research has shown that for every one-cent increase in the loonie relative to the greenback, it costs Canadian companies $1.5-billion more to do business globally each year.

Mr. Brownlee said the volatility of the loonie makes it hard for Canadian companies that sell their products abroad to plan expenses.

“A lot of exporters are forced to be basically like fortune tellers to try to figure out where the value of the loonie is going to be in six or eight months time,” he said.

As the loonie rises, Canadian products become more expensive to sell abroad, making it harder for Canadian companies to compete with manufacturers in countries with weaker currencies.

Some Canadian companies are spending their more valuable loonies on buying new, innovative equipment so they become more productive and better able to compete, Mr. Brownlee said.

But that automation and financial investment means some jobs and even businesses could be at risk.

“Any time that the dollar goes up like that there's always the potential (for job losses) when companies are forced to find efficiencies, and certainly since 2002 there have been a lot of job losses in the manufacturing industry,” he said, adding that since the recession many companies are already running lean in order to compete globally.

Article provided via the Globe and Mail

http://www.theglobeandmail.com/report-on-business/economy/currencies/for-firms-new-twist-on-strong-canadian-dollar/article1978943/

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