April 20, 2010 / 1:08 PM / 7 years ago

Bank of Canada sets stage for rate hike, a G7 first

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<p>Bank of Canada Governor Mark Carney speaks during a news conference upon the release of the Monetary Policy Report in Ottawa October 22, 2009.Chris Wattie (</p>

OTTAWA (Reuters) - The Bank of Canada signaled on Tuesday it may raise interest rates as soon as June, making it the first G7 central bank willing to end emergency-level lending rates introduced during the crisis as the economy roars back after the recession.

The bank kept its benchmark rate at 0.25 percent, the record low level it has been at for the past year. But after surprisingly high inflation and growth numbers, it abandoned a conditional pledge to hold the rate at that level until the end of June.

"With recent improvements in the economic outlook, the need for such extraordinary policy is now passing, and it is appropriate to begin to lessen the degree of monetary stimulus," it said in a statement.

"The extent and timing will depend on the outlook for economic activity and inflation, and will be consistent with achieving the 2 percent inflation target."

The central bank next sets interest rates on June 1, and then on July 20. It previously said it would hold rates steady until the end of the second quarter, unless inflation strayed off course.

"This is a more hawkish than expected statement," said Doug Porter, deputy chief economist at BMO Capital Markets.

"Quite simply, June is definitely on the table as a possibility for the bank to begin hiking rates."

Most of Canada's primary securities dealers moved up their forecast for a first rate hike to June from July after the bank's statement.

In a Reuters poll after the announcement, 11 of 12 dealers expected the central bank would boost rates June 1. In a poll last week, eight of the 12 expected a July hike and only three forecast a first move in June. All dealers now see rates rising at least 25 basis points in both July and September.

Yields on overnight index swaps, which trade based on expectations for the central bank's key policy rate, edged higher after the statement was released and now suggest there is a 93 percent chance of a June rate hike.

The statement sent the Canadian dollar higher, pushing it above the U.S. dollar for the first time this week to a high of C$0.9978 per U.S. dollar, or $1.0022, from around C$1.0114 to the U.S. dollar, or 98.87 U.S. cents earlier.

Canadian bonds sold off, with short-term bonds, the most sensitive to interest rates, seeing the most pressure.

Canada's recession was milder and shorter than the previous two downturns and it has bounced back with more zest than even the most bullish economists had predicted, putting it at the head of the G7 pack.

Other major, developed economies like the United States and the European Union are in no rush to tighten monetary policy, with Asian central banks leading the world in exiting from record low rates.

Sharp Growth Revision

Growing demand from emerging markets for commodities, resilient consumer spending and a domestic housing boom helped the Canadian economy expand by 5 percent in the fourth quarter of last year. Analysts expect a similar performance in the first quarter.

The central bank's January forecasts were hopelessly downbeat by comparison, and on Tuesday it sharply raised its annual 2010 growth outlook to 3.7 percent from 2.9 percent. But it lowered its growth forecast for 2011 to 3.1 percent from 3.5 percent and sees the pace easing even further in 2012 to 1.9 percent.

The economy will return to full capacity in the second quarter of 2011, not the third quarter as it said previously.

Quarterly forecasts will be released on Thursday in the bank's monetary policy report.

The bank issued a couple of warnings to temper any overly confident bets on a June rate hike, saying the current upswing may be the result of Canadians "front-loading" spending in late 2009 and early 2010 to take advantage of low interest rates, and said this is not likely to last. It also highlighted threats to growth.

"The persistent strength of the Canadian dollar, Canada's poor relative productivity performance, and the low absolute level of U.S. demand will continue to act as significant drags on economic activity in Canada," it said.

The changes to the inflation outlook were less stark than those to growth, surprising some analysts.

"That's a large increase for 2010 growth ... Their language with inflation seems still to be somewhat muted," said Camilla Sutton, currency strategist at Scotia Capital.

The bank said core inflation, which caused alarm in February when it tipped above the bank's 2 percent target, will ease in the second quarter as the effect of temporary factors dissipates, and will remain near target after that.

Total CPI will hover above 2 percent for much of 2010 and return to target in the second half of 2011.

In another sign of its plans to return to normal, the bank said it will discontinue term purchase and resale agreements, one of the emergency financial tools it introduced during the crisis to make short-term loans to market players.

Reporting by Louise Egan; editing by Janet Guttsman and Peter Galloway

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