Bank of Canada signals no rush to normalize rates

Wed Jul 20, 2011 3:52pm EDT
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By Randall Palmer and Louise Egan

OTTAWA (Reuters) - A day after raising expectations it would increase interest rates soon, the Bank of Canada said it might keep rates below their normal long-run levels even after the Canadian economy is back to full capacity, and future rate hikes would likely be gradual.

In a report on Wednesday, and in remarks by Governor Mark Carney, the central bank took pains to say that, as the economy approaches full capacity in mid-2012 and inflation converges on its 2 percent target, markets should not assume interest rates will necessarily rise as quickly to more traditional levels above inflation by then.

"You cannot mechanically assume that because the output gap on our projection -- the output gap is closed in the middle of 2012 -- that the bank's target interest rate will be back at neutral, however you define neutral," Carney said in a news conference.

"And in fact, I said further and I'll reiterate it today, that if it were, then the output gap wouldn't close over that horizon and inflation would not be back at target. And why is that? Well, there are considerable headwinds in the Canadian economy."

The strong Canadian dollar, weak U.S. recovery and the European sovereign debt crisis are the major risks to Canada, he said.

The bank held its key interest rate steady at 1.0 percent on Tuesday, as expected, and appeared to clear the path for rate increases in a statement that dropped the term "eventually" for when it would move.

But in another signal the bank will not hike rates aggressively, Carney emphasized that the statement also refers to only "some" of the considerable monetary policy being removed.

Some market players have speculated that in order to reach what is considered a neutral rate -- which would have to be well above the inflation rate -- the bank would have to raise rates rapidly ahead of mid-2012.   Continued...

<p>Mark Carney, the Governor of the Bank of Canada, delivers a speech to the Vancouver Board of Trade in Vancouver, British Columbia June 15, 2011. REUTERS/Ben Nelms</p>