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VICTORIA, British Columbia (Reuters) - Canadian exports were unexpectedly weak over the past two years, partly due to U.S. budget cuts and the expiration of tax breaks known as the "fiscal cliff," that took effect early last year, a senior Bank of Canada official said.
Deputy Governor John Murray said in a speech on Thursday that lackluster Canadian economic growth and three puzzling trends - weak inflation, investment and exports - could be partly explained by international factors.
He also pointed to Australia as evidence supporting the central bank's forecast for a soft landing for the Canadian housing market.
With respect to exports, there has been an apparent disconnect between foreign demand, particularly in the United States, and the performance of Canadian non-commodity exports.
This has surprised policymakers, but Murray said recent evidence suggests exports rely more heavily than thought on demand from U.S. governments at the federal, state and local level, with about 12 percent of non-commodity exports from 1997 to 2012 going to the U.S. government sector.
By recognizing that, and incorporating it into the bank's measure of foreign activity, the bank is better able to understand how exports behave, he argued.
"It relates to the fiscal cliff in the United States and the significant budget consolidation that has been underway there in the past two years," Murray said in his last public speech before retiring on April 30.
The fiscal cliff refers to expiring U.S. tax breaks and spending cuts from January 1, 2013, which had the potential of pushing the U.S., Canada's biggest trading partner, back into recession in the absence of an alternative deficit-reducing political deal.
Murray stressed that the alternative explanation was not the only cause of weak exports and warranted further investigation.
Canada emerged relatively unscathed from the global financial crisis but its economy has failed to grow fast enough to merit a return to normal monetary policy. The government and central bank are trying to figure out how to lift growth without relying on indebted consumers.
The Bank of Canada has held its benchmark rate at 1.0 percent for over three years. On Wednesday, it left the rate unchanged again and reiterated its neutral stance. Analysts are predicting a rate hike in the third quarter of next year. <CA/POLL>
In addition to scratching their heads over the lagging exports in Canada, central bank officials have had trouble understanding why inflation has stayed below the bank's 2-percent target for so long and why business investment has not bounced back as expected after the 2008-09 recession.
These trends are international too and better understood when seen in that context, Murray said.
"While it is important to interpret with caution what you see through the international lens, we have seen how it can help us resolve domestic economic puzzles and guide policy."
For example, Canada has learned from other countries that the effect of output gaps on inflation has a longer lag than previously thought, when these gaps are large and persistent.
He warned against getting too excited over a pickup in the inflation rate in January to a 1-1/2-year high of 1.5 percent, predicting the number would go down again in February because of the effects of price increases a year earlier in automobiles and semi-durable goods.
"So we're still dealing with a situation, which (is) Canada's inflation is weak and because of where it is relative to our target, it remains a concern," he said.
With regards to business investment, another laggard, U.S. researchers have shown that uncertainty is making companies shy away from new projects.
The world beyond Canada also provides possible scenarios, good and bad, for the country's heated housing market and record-high household debt.
It would be a mistake to assume Canada is inevitably headed for a crash, Murray said, even though its debt and housing prices are comparable to those in the U.S. and Britain before their respective crises.
"International evidence also provides some support for this more benign scenario," he said. "Countries such as Australia have managed a soft landing and the preconditions for this, one could argue, are even more favorable in Canada.
Writing by Louise Egan and David Ljunggren; Editing by Bernadette Baum