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OTTAWA/TORONTO (Reuters) - Strong housing starts and a marked improvement in the business outlook revealed on Monday that the Canadian economy is humming along at a healthy pace, adding pressure on the Bank of Canada to raise interest rates.
The central bank must weigh evidence of a frothy domestic economy against a bleak global backdrop, including signs of economic stagnation in the United States, the country's dominant trade partner.
The hiring intentions of businesses were at a record high in the second quarter and the outlook on sales, investment and financing was upbeat, according to the central bank's second-quarter business outlook survey.
The survey results suggest more companies are operating at full capacity but do not fear generating inflationary pressures.
"That is consistent with our expectations that growth in the third quarter will bounce back from its lull in the second quarter," said Emanuella Enenajor, an economist at CIBC.
"And the added indicators of capacity pressures suggest the bank has more justification to begin gently removing monetary stimulus in the coming months," she wrote in a note to clients.
Housing starts for June surged well past market expectations, monthly data from Canada Mortgage and Housing Corp showed on Monday, adding to two months of upward revisions and raising second-quarter growth expectations.
Starts rose 1.7 percent in June from May to a seasonally adjusted annualized rate of 197,400 units.
Scotia Capital economists noted starts notched their first quarterly gain in three quarters, up 6.7 percent.
"This should provide a boost to Q2 real GDP, offsetting some of the weakness resulting from Japan's supply chain constraints," said Scotia Capital economists Derek Holt, Karen Cordes Woods and Sarah Howcroft in a note to clients.
The Bank of Canada estimates the economy slowed to 2 percent annualized growth but will speed up to 2.7 percent in the third quarter. Those forecasts may change in its quarterly update on July 20.
The central bank is widely expected to hold its key interest rate unchanged on July 19. Normally, the strong data would prompt it to give a clearer signal of plans to resume tightening later this year.
But the global situation has worsened since the survey was conducted May 24-June 16 -- including weak U.S. employment data, rising Chinese inflation and fresh euro zone woes -- and the bank may question how sustainable the good news is.
Still, analysts generally expect the domestic strength to keep the bank on track for a rate hike at some point before year-end.
"Current business optimism might not be as upbeat as it was 25 days ago, owing to recent U.S., Chinese and European developments," said Michael Gregory, senior economist at BMO Capital Markets.
"But even if business expectations have become moodier, they still started from a position of relative, absolute and surprising strength," he said.
Yields on overnight index swaps, which trade based on expectations for the central bank's policy rate, continued to reflect almost zero chance of a rate move on July 19. But rate hike expectations rose following Monday's data for decision dates in September, October and December.
The bank has held its key policy rate steady at 1 percent since last September following three successive hikes to lift it from emergency lows.
Most of the businesses surveyed -- 80 percent -- see inflation staying within the bank's 1-3 percent target range, but a greater number see the rate in the upper end.
A more compelling survey item showed the share of firms reporting some difficulty in meeting an unexpected increase in demand rose to 46 percent, the highest since 2000, although those that expected "significant" difficulty in meeting demand was low at 5 percent.
"The key question is that if these pressures will convince the bank to look beyond an increasingly bleak international outlook to a healthy domestic backdrop," said David Tulk, an economist at TD Securities.
"While this report does not make it easy, it is not sufficiently hawkish, in our view, to warrant a change in focus at this point," he said.
In a June 29 poll, most of Canada's primary securities dealers expected the next hike to come in September.
Editing by Peter Galloway and Rob Wilson