OTTAWA (Reuters) - Canada's economy will avoid a recession, despite a contraction in the first quarter, but small budget deficits are likely in 2008 and 2009, a report by the OECD said on Wednesday.
"The general government is projected to show small deficits for both years (2008 and 2009), and governments will have to stick to their spending plans closely to avoid dipping into the red on a more sustained basis than projected," the Organization for Economic Co-operation and Development said in its semi-annual outlook on Canada's economy.
Federal Finance Minister Jim Flaherty said the comments by the OECD reflected both federal and provincial spending plans, and he insisted that Ottawa would remain in surplus.
"What the report said is that, overall, governments in Canada might run deficits this year and next. Certainly the federal government will not," he told reporters.
Canada is the only member of the Group of Seven industrialized countries to consistently post budget surpluses, and it could be politically risky for the minority Conservative government to slide into deficit.
The OECD also said that the Bank of Canada needs to continue lowering interest rates. The bank has slashed its overnight rate by 150 basis points since December to help the economy recover next year from the effects of the U.S. slowdown.
"Further easing of monetary policy will be required to give a needed boost to the economy in 2009 and at the same time avoid putting additional upward pressure on the currency," the report said.
The outlook, usually conducted in co-ordination with official policy-makers in Ottawa, supports market expectations for at least one more rate cut by the central bank on June 10.
The Paris-based OECD said Canada's strong domestic demand and employment meant it was headed for a "relatively mild" slowdown. But it sharply cut its forecast for 2008 economic growth to 1.2 percent from a December estimate of 1.7 percent.
The federal government has so far stuck to its most recent estimate of 1.7 percent growth, made in the February budget.
The Bank of Canada's projections, released in April, also now appear on the high side, with forecasts of annualized quarterly GDP growth of 1 percent in the first quarter, 0.3 percent in the second quarter and 1.8 percent in the second half of this year.
Ted Carmichael, chief economist at JP Morgan Canada, points out that the OECD's reports usually present a view that coincides with that of the Finance Department and Bank of Canada.
"The OECD's comments on Canada should be viewed as an indication that policy-makers continue to see further cuts in the policy rate as necessary to offset the strong headwinds provided by the expected protracted U.S. slowdown, previous Canadian dollar appreciation, and the continuing impact of credit market distress," Carmichael wrote in a research note.
The strong currency and slowing economy will help keep inflation at its current low levels, giving the central bank plenty of room to ease rates, the OECD said. Despite early signs of building inflationary pressure, that will not require a response via rate hikes until early 2009, it said.
"The OECD report clearly suggests that the BoC should give more weight to the forces pointing to a protracted period of sub-potential GDP growth than to what may prove to be temporary upward pressures on inflation," said Carmichael.
Ottawa should be careful to stick to its cautious spending plans as weaker economic growth, combined with aggressive tax cuts last year, bit into government revenues.
Reporting by Louise Egan; editing by Rob Wilson