Bank of Canada holds off on interest rate hike

Bank of Canada holds off on interest rate hike, for now

SIMON TUCK

Globe and Mail Update

April 24, 2007 at 11:39 AM EST

Ottawa — The Bank of Canada has again decided to leave its benchmark overnight lending rate alone, but has opened the door to a rate hike in the coming months.

The central bank announced Tuesday that the key lending rate will remain at 4.25 per cent, where it's been since May 24 of last year. The decision marks the bank's seventh consecutive scheduled setting at which there has been no change.

But the announcement was significant in that the Bank lowered its forecast for economic growth, while pointing out that domestic inflation is bubbling above expectations and has clearly become a concern.

Governor David Dodge said the economy is now expected to grow by 2.2 per cent this year and 2.7 per cent for 2008, down slightly from the 2.3 per cent and 2.8 per cent respective increases that were forecast in January.

On the inflationary front, the Bank said it now views the risks with "a slight tilt to the upside" although there was no clear signal that any rate increase was imminent.

Mr. Dodge said he now expects the all-items inflation rate to rise to more than 2 per cent in the second half of this year, compared to the 1.7 per cent forecast from January.

"Pressures on capacity over the past year have been stronger than previously judged," the central bank said in its release. "Also, food and gasoline prices have recently risen more than expected."

While the U.S. economic slowdown is biting into exports and modifying Canada's growth rate, the bank said strong domestic demand from outside North America is driving the economy — and inflationary pressures.

"The Bank now judges that the Canadian economy was operating just above its production capacity in the first quarter of this year."

Ted Carmichael, chief economist for J.P. Morgan Securities Canada, wrote in a note that it was surprising that the bank's statement didn't explicitly say that rate increases may be necessary. Mr. Carmichael said he's sticking with his forecast for a 25 basis point hike in the central bank's Sept. 5 rate decision. "The [Bank of Canada's] tolerance for sustained total inflation above the 2 per cent target is likely to be limited."

Some other economists, however, didn't see the Bank's announcement as particularly hawkish on inflation.

Douglas Porter, deputy chief economist at BMO Nesbitt Burns Inc., said Mr. Dodge and his colleagues hedged their bets by stating the risks were still "roughly balanced" between inflation and sluggish growth. Mr. Porter said he doesn't expect a rate hike until the second half of next year.

But the Bank's isn't alone in its recent concern about inflation. The previous ammunition came last week when Statistics Canada revealed that core inflation in March hit 2.3 per cent, down from 2.4 per cent in February but still above the bank's target of 2.1 per cent.

And four of the nine private sector economists on the so-called Monetary Policy Council at the C.D. Howe Institute recommended a rate hike to 4.5 per cent prior to Tuesday's announcement.

Royal Bank of Canada said Tuesday in an economic update that the central bank will likely be paying more attention to inflation because core inflation remained a bit high in March and is unlikely to move back to the 2 per cent target in the near-term.

Michael Gregory, senior economist at BMO Nesbitt Burns, said he expects the central Bank to boost its second quarter projections for both core inflation and total consumer price index inflation when it releases its semi-annual Monetary Policy Report on Thursday.

Even Mr. Dodge had been providing grist for the mill. He dismissed the threats imposed by choppy markets last month when he said in a statement: "Despite recent volatility in global financial markets, the bank continues to judge that the risks to its inflation projection are roughly balanced," the bank's statement said.

The downside risk for Canada — as has long been the case — is that the U.S. economy could slow down rapidly, hurting Canadian growth. But there's a risk of overheating the economy if Canadian consumers embark on a spending spree by borrowing against their increasingly valuable houses, the bank said at the time.

And in speech earlier this year, Mr. Dodge said he was keenly watching for any sign of upward pressure on inflation — whether those signs come from wage data, labour market reports, or the bank's own surveys of businesses.

But he also kept watch at that time on both flanks, saying the upward and downward pressures balanced out and that inflation was expected to stabilize at about 2 per cent soon.

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