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OTTAWA (Reuters) - Canadian growth will pick up speed this year after a sharp slowdown in the third quarter of 2010, but the strong Canadian dollar will mute a much-needed recovery in exports, the Bank of Canada predicted on Wednesday.
The bank, which held its key interest rate steady at 1 percent on Tuesday, issued cautious forecasts and flagged the country's worsening competitiveness in a report that further solidified the market view that rates will remain on hold for some time.
It said that from now on the country's economic recovery will rely more on exports and business investment and less on consumer spending, housing and government stimulus, which have driven growth thus far.
But exporters will have to battle a strong currency, assumed by the bank to remain at parity with the U.S. dollar. The bank also flagged an issue that it sees as a major headwind in the medium term -- Canada is becoming less competitive and losing market share in the United States, by far its top market, to Mexico and other countries because of poor productivity.
Analysts said the bank's Monetary Policy Report reinforced Tuesday's interest rate statement, which markets interpreted as dovish.
Krishen Rangasamy, economist at CIBC World Markets, said that the bank's modest upward revision to economic growth forecasts for this year and next were partly explained by its new assumption that the Canadian dollar will on average stay at parity with the U.S. currency.
"We continue to expect the BoC to resume its tightening cycle in May, taking the overnight rate to 2 percent by year-end," she wrote in a note to clients.
The bank raised rates three times between June and September last year before hitting the pause button. Most of Canada's primary dealers expect another rate increase in the first half of this year, although they differ on the timing.
The Canadian dollar extended losses after the report to reach a session low of C$0.9964 to the U.S. dollar, or $1.0036, from C$0.9930 earlier on Wednesday.
Bank of Canada Governor Mark Carney shied away from a judgment on whether the Canadian dollar's recent strength was justified by the economy's health, shifting the focus instead to the ability of business to compete in a tough new environment.
"We have lost competitiveness over a number of years. That's a product of the level of the currency, it's a product of poor relative productivity performance ...," Carney told reporters at a news conference following the release of the report.
Improved global demand and high commodity prices will help boost fourth-quarter growth to an annualized 2.3 percent, up from 1 percent in the previous quarter, the bank estimated. It sees growth rising to 2.5 percent in the first quarter and hitting 3 percent in the second half.
Exports will contribute more to growth this year than last, but will remain sluggish.
The bank now sees the U.S. economy expanding by 3.3 percent this year, up a percentage point from its previous forecast, due to the monetary policy easing and fiscal stimulus there. That will boost Canadian growth by about 0.2 percentage points this year and 0.1 percentage points in 2012, it said.
But Canada will not fully benefit from that mark up in U.S. growth because Washington's fiscal package should increase U.S. consumer spending rather than housing and other forms of investment that help Canada's hard-hit forestry and wood products industries, the bank said.
"The composition of the fiscal package ... is more heavily weighted to the household sector, to consumption, than to the business side and the composition of our exports is weighted to the contrary," Carney said.
Canadian business investment has recovered but is still far below pre-recession levels, and could take some time to fully recover in what the bank sees as a "tougher external environment for some time".
The bank assumes the Canadian dollar will stay at parity with the greenback, in line with the rate since last December's interest rate announcement. This is the first time it has assumed such a high value for the currency, although Carney emphasized it is "not a forecast".
The bank welcomed the government's announcement this week that it would tighten mortgage rules to help curb household debt, a source of alarm for the bank. But Carney warned the issue would not be resolved "instantly" and that household debt levels would remain near historic highs.
The bank expects core and total inflation to reach 2 percent by the end of next year and noted that that inflation expectations "remain well anchored".
"This remains a central bank committed to its view that excess capacity does not get closed off until the end of 2012 ... That says to us that using standard policy lags, the Bank of Canada is on hold (on interest rates) until this fall," said Scotia Capital economists Derek Holt and Gorica Djeric in a note.
Reporting by Louise Egan and Leah Schnurr; editing by Janet Guttsman and Peter Galloway