NEWS / Foreign Exchange

Pickup in Housing Starts Partly Influenced by Weather, But Weak Underlying Trend Unchanged

Housing starts rose 9.0% to an annual rate of 1.525 million units after a 14.3% decline in January. Starts of new homes rose in the West (+26.4%) and South (+18.0%) but fell in the Northeast (-29.7%) and Midwest (-14.4%). Bad weather in the Northeast and Midwest held down home construction, while construction friendly weather in the South and West helped to raise starts.

In three months ended February, weather has played a role in construction activity. To minimize the impact of weather, a 3-month moving average of housing starts (both total starts and single-family starts) is probably a better indicator of underlying fundamentals. The current three-month moving averages of total housing starts and single-family starts (see chart 2) match the levels last seen in late-2000. The 3-month moving average of single-family starts is down 33.0% from its peak in November 2005.

Permits issued for new homes fell 2.5% in February. Permit extensions have declined for 14 out of the last 17 months. The number of permits issued in February (1.532 million) is the lowest since December 1997, excluding a lower reading in November 2006. The most important message is that home construction is yet to show signs of stabilization.

Canada: Supply Disruptions Push Up February Inflation

The Consumer Price Index (CPI) posted its largest monthly gain since September 2005 in February (0.7%), driven up by higher prices for gasoline, fresh vegetables (largely due to US harvest problems) and housing-related costs. On a year-over-year basis the all-items index moved up 2.0%, a substantial acceleration from the 1.2% increase posted in January. The Bank of Canada??™s (BOC) core index climbed to 2.4%, from 2.1% a month earlier, but remains anchored within the official targeted range of 1-3%.

The inflation story in Canada continues to revolve around the epic battle between the energy and housing markets. Production disruptions caused by a fire at an Ontario refinery and a labor strike in Alberta caused gasoline prices to jump in affected provinces. This pushed up energy prices for the month despite sustained declines in natural gas prices, which were 19.3% lower in February than a year earlier, following a 21.5% drop posted in January.

Mortgage interest costs and homeowner??™s replacement costs rose 5.3% and 7.1%, respectively, following 12-month changes of 5.1% and 7.6% in January. Levels have gradually receded as the booming housing market has cooled in the Western provinces and are fully expected to continue falling in coming months. Housing-related costs account for more than a quarter of the CPI basket and replacement costs, unlike mortgage interest costs and gasoline prices, are included in the BOC??™s core measure.

All told, we admit we were a bit surprised by the surge in February??™s inflation report. But as Paul Kasriel is want to say: one month does not a trend make. The BOC has held its benchmark interest rate steady at 4.25% since last May and is expected to maintain the overnight rate at 4.25% over the coming months.

Debate rages over whether the next action taken by the BOC will be a hike or a cut, particularly following the decision of the separatist Bloc Quebecois party to support the Conservative government??™s expansionary budget proposal. The minority government??™s proposed budget calls for a sizeable increase in spending, particularly for provincial outlays. Program spending for the FY07/08 budget (ending next March) is forecasted to increase by 5.6%, following a 7.9% increase in the current fiscal year. The increased spending coupled with planned tax cuts for families and seniors is expected to inject an additional C$7.4billion into the economy.

Analysts were quick to point out the potential inflationary risks associated with an expansionary fiscal policy in the context of an economy already operating close to capacity. While we are not ignoring the fiscal-monetary policy link, we are not yet ready to abandon our call that the next move by the BOC will be a rate cut either in late 2007 or early 2008. Downside risks from slowing economic conditions in the US, a cooling domestic housing market and moderating energy prices and production remain in tact. Instead, we will wait for the data to signal a trend.