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After a marked slowdown during the first half of 1995, economic activity in Canada picked up modestly in the third quarter, supported by a rebound in exports and a revival in the household demand for durables. Driving these developments were a strong increase in U.S. aggregate demand and the earlier easing in Canadian interest rates. Moderating the pace of economic expansion in the third quarter were efforts by firms to reduce the rate of inventory accumulation, further cuts in government spending and continued declines in residential construction. Given excess capacity in the economy and the transitory nature of some of the factors that have been holding core inflation in the upper half of the target band for the past six months, trend inflation is expected to decline in the near term. This view is supported by the absence of cost pressures in the economy and the moderate growth of the broad monetary aggregates.
On balance, the external economic environment remains positive for Canada. Although the pace of expansion in the major European countries has slowed, and economic activity in Japan remains very sluggish, the U.S. economy has rebounded and seems poised to achieve a more sustainable, low-inflation pace of expansion. As well, after further gains in the third quarter, the average price of the key commodities produced by Canada remains firm.
With increasing evidence of a sharp slowdown in the first part of 1995, the Bank took steps through the late spring and early summer to ease monetary conditions.(1) However, this easing was reversed and in fact monetary conditions tightened slightly over the summer, as growing market focus on Canada's efforts at fiscal adjustment led to an appreciation of the exchange rate, while the Bank proceeded cautiously in adjusting downward the operating band for the overnight rate ahead of the Quebec referendum. With the launching of the referendum campaign in September, Canadian financial markets entered a period of heightened nervousness and volatility, which culminated in strong downward pressure on the Canadian dollar and sharp increases in money market interest rates in late October. The Bank kept the operating range for the overnight rate unchanged through this period, as monetary policy operations were guided primarily by the need to stabilize markets. With money and foreign...