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OTTAWA (Reuters) - The Bank of Canada warned on Tuesday that it would eventually have to lift borrowing costs if the economy continues expanding, introducing some hawkish language that caught many in the market off guard.
The statement by the central bank -- which kept its key interest rate unchanged at 1 percent -- drove the Canadian dollar and short-term bond yields higher as traders increased bets on rate hikes later this year.
"To the extent that the expansion continues and the current material excess supply in the economy is gradually absorbed, some of the considerable monetary policy stimulus currently in place will be eventually withdrawn," the central bank said in a statement.
It added that "consistent with achieving the 2 percent inflation target. Such reduction would need to be carefully considered,"
The markets interpreted "eventually" to mean not the next rate decision in July, but later in 2011.
Previous statements had only said that any future hikes "would need to be carefully considered."
Finance Minister Jim Flaherty, who meets Bank of Canada Governor Mark Carney regularly, told reporters on Tuesday it had been clear for some time that rates would rise, "so consumers ought to bear that in mind when they assume debt."
"It doesn't sound like the central bank is gearing up for a rate hike in July but the warning that rate hikes will eventually come suggests that we'll see a few hikes before the end of the year," said CIBC chief economist Avery Shenfeld.
"Markets had priced out nearly all of the risks of a hike not only in July but September as well. I think the bank was uncomfortable with the market starting to assume that it was going to wait forever to begin hiking."
Overnight index swaps, which trade based on expectations for the key central bank policy rate, showed investors see less than a 6 percent chance of a rate hike in July.
But swaps traders initially increased the probability that the central bank will tighten at some point after July. The central bank has scheduled policy announcements in September, October and December.
A Reuters poll of Canada's 12 primary dealers showed a median view that the overnight rate would rise to 1.25 percent in September, compared with a median view of July in a poll taken on April 19. Nine of the dealers see rates at 1.25 or 1.50 percent by September.
The central bank became the first in the Group of Seven advanced economies to tighten monetary policy following the global financial crisis. It hiked rates three times from June to September last year, then paused due to the weak global recovery.
The bank now sees underlying inflation as only "relatively subdued" rather than "subdued" as in previous statements, but it did not change its overall outlook for inflation.
"It's a subtle change. And I think that's the theme here. They certainly didn't bang us over the head with any obvious changes, but there were a few very subtle shifts in the language," said BMO Capital Markets deputy chief economist Doug Porter.
"I do think they are eventually preparing the ground for rate hikes, but there's very little here to suggest that the bank has had a big change of heart."
Governor Carney has said in the past he does not want Canadian rates to diverge too far from U.S. rates, which are not likely to rise in the near future, yet he also has to guard against overheating in Canada.
The bank statement repeated that the persistent strength of the Canadian dollar "could create even greater headwinds for the Canadian economy" and dampen inflation.
And temporary supply chain disruptions from Japan will sharply restrain growth in the second quarter. But it expects this to be unwound in subsequent quarters.
It said the U.S. economy continued to grow modestly and European growth was maintaining momentum, but risks to peripheral European economies had increased.
The Canadian dollar climbed as high as C$0.9653 to the U.S. currency, or $1.0359, up from C$0.9723 to the U.S. dollar, or $1.0285, immediately before the Bank of Canada statement. It was the Canadian dollar's strongest level since May 20.
Short-dated bond prices, which are most sensitive to the interest rate outlook, initially deepened losses after the Bank of Canada news.
With additional reporting by Claire Sibonney, Ka Yan Ng and Solarina Ho in Toronto; Editing by Jeffrey Hodgson