June 1, 2012 / 7:59 PM / 5 years ago

Bank of Canada may rethink rate-hike intentions

OTTAWA (Reuters) - The Bank of Canada may signal on Tuesday that it is more reluctant to raise interest rates than it was seven weeks ago, without completely reversing its message that Canadians should start preparing for higher borrowing costs down the road.

In its last rate announcement on April 17, the central bank surprised markets with a warning that monetary tightening “may become appropriate”, raising speculation it could start lifting its main policy rate from the current 1 percent as early as this fall.

But it may now be forced to gracefully backpedal because of the sputtering U.S. recovery and renewed turmoil in Europe, which the European Central Bank (ECB) and Bank of England (BOE) are watching closely.

“The Bank of Canada has to take a moderate step backward in its hawkish rhetoric as opposed to risking being the only hawkish central bank in a week in which the ECB could well cut, and each of the BoE and RBA (Reserve Bank of Australia) is likely to stand pat but with a dovish bias,” said Derek Holt, economist at Scotiabank.

In fact, this is the second time in a year that the Bank of Canada Governor Mark Carney has set the stage for an eventual rate hike, only to be sideswiped soon after by an escalation of the European debt crisis.

NO RATE MOVE SEEN TUESDAY

The central bank’s April 17 statement was reminiscent of a similar burst of optimism in May 2011, when it signaled intentions to tighten monetary policy. By October it had done a complete about-face.

The jury is still out on whether the bank’s statement on Tuesday will soften the sentence on the withdrawal of stimulus, or leave it intact and instead flag increased worries about risks from abroad.

The April language is sufficiently vague to let it largely stand until July, when the bank issues its quarterly monetary policy report, the preferred vehicle for explaining shifts in policy.

Canada’s central bank was the first in the Group of Seven advanced economies to lift rates following the global financial crisis. But after three successive increases, the benchmark overnight rate target has been unchanged since September 2010.

Nobody expects a move this month. Forecasters recently polled by Reuters expect the next hike to be in the first quarter of 2013. <CA/POLL>

Yet the market for overnight index swaps is pricing in the possibility of a quarter-point rate cut by the end of this year. By contrast, bank economists still see the next move as a hike, not a cut.

“They’re not going to give any comfort to the market ... Governor Carney isn’t going to blow completely with the wind,” said Avery Shenfeld, chief economist at CIBC World Markets.

GROWTH BELOW TARGET

Weighing on the bank’s decision will be first-quarter economic growth of 1.9 percent annualized, below its own projection of 2.5 percent.

The growth is also below the bank’s estimate of the economy’s capacity to grow, which is 2 percent a year. That implies the output gap - the difference between potential and actual output - will take longer to close.

A bigger output gap would make the bank less likely to raise interest rates because it reduces the chance of inflation heating up.

On the other hand, second quarter growth may come in stronger as temporary plant shutdowns that dampened first-quarter growth will no longer be in play, analysts said.

“As a result, the central bank may upwardly revise its current second-quarter 2012 growth rate of 2.5 percent in an offsetting manner with the release of the next Monetary Policy Report in July,” said Paul Ferley, assistant chief economist at RBC Economics.

Editing by Jeffrey Hodgson

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