OTTAWA (Reuters) - The Bank of Canada issued a more upbeat outlook for the Canadian and global economies on Thursday, suggesting that an interest rate hike may be back on its radar screen, albeit not immediately.
The central bank maintained its overnight lending rate target at 1 percent, mirroring decisions by the European Central Bank and the Bank of England and extending its freeze on borrowing costs for an 18th month.
In a statement, it said the Canadian economic outlook was "marginally improved", uncertainty around the global economy had decreased and the profile for inflation was somewhat firmer than it had foreseen.
It also warned about the dangers of high household debt levels in a sign of increasing worry about Canadians taking on too much mortgage debt at ultra-low rates. Canada's housing market has been strong, prompting some talk of a housing bubble or a price correction of some sort.
"Canadian household spending is expected to remain high relative to GDP as households add to their debt burden, which remains the biggest domestic risk," the bank said.
The Canadian dollar firmed to C$0.9925 versus the U.S. dollar, or $1.0076, immediately after the announcement, up from C$0.9955, or $1.0045, going into the statement.
The more hawkish language sent short-term bond yields higher as traders priced in the possibility the central bank will tighten policy sooner than previously thought. The yield on the two-year Canadian government bond, which is especially sensitive to Bank of Canada interest rate expectations, rose to 1.154 percent from 1.139 percent just before the release.
Yields on overnight index swaps showed traders had all but ruled out the prospect of rate cuts this year, whereas they had been pricing in a rate cut for the past few months.
That now looks unlikely, given that the bank says it sees "tentative signs" of stabilization in the European debt crisis, a modest U.S. expansion and high commodity prices.
But analysts still do not expect Canada to raise rates too far ahead of the U.S. Federal Reserve, given that higher Canadian interest rates could drive up the Canadian dollar.
"It shows a little bit more of a hawkish bent. It's not enough to change their official bias," said Mark Chandler, head of fixed income and currency strategy at RBC Capital Markets.
The bank said there is "considerable monetary policy stimulus" in Canada, but it made no mention of the need to withdraw that stimulus eventually, as it did in May and July of last year.
Tempering its optimism was the fact that temporary factors will be behind the likelihood of stronger than expected annualized growth for the first quarter. Exports will contribute little to growth despite stronger U.S. demand, because of the persistent strength of the Canadian dollar and competitiveness challenges, it added.
Camilla Sutton, chief currency strategist at Scotia Capital, called the statement "less dovish" and said the Bank of Canada looks set to tighten policy slightly ahead of schedule. "But that's still a 2013 story. It's not a 2012 story," she added.
Analysts surveyed by Reuters last month expected the Bank of Canada to keep rates on hold until the second quarter of 2013.
The bank said the outlook for total inflation and core inflation looked firmer than it had predicted in January.
"After moderating in the second quarter, total inflation is expected, along with core inflation, to be around 2 percent over the forecast horizon, reflecting the combination of modest growth of labor compensation, an economy operating around its potential over time, and well-anchored inflation expectations," it said.
Bank of Canada Governor Mark Carney has signaled that the inflation target is "flexible", meaning he could refrain from rate increases even after inflation returns to its 2 percent target and the economy returns to full capacity.
Additional reporting by Jennifer Kwan, Claire Sibonney and Jon Cook; Editing by Jeffrey Benkoe & Theodore d'Afflisio