(Adds background, market reaction, analyst comments)
By Leah Schnurr and David Ljunggren
OTTAWA, Feb 10 (Reuters) - The Canadian economy is still operating below its potential, a senior Bank of Canada official said on Tuesday, pointing to slack in the labor market and calling the recent sharp drop in oil prices a “setback.”
In some of the first remarks by a Bank of Canada policymaker since a shock interest rate cut last month, Senior Deputy Governor Carolyn Wilkins laid out the reasons for the surprise move, reiterating that the bank thought it would take too long to close the output gap if it did not act.
Wilkins said measures of slack in the labor market were showing greater unused capacity than broader economic measures.
“There is no doubt that the Canadian economy has room to grow,” Wilkins said in a speech.
Still, Wilkins expressed confidence that with a stronger U.S. economy, a lower Canadian dollar and an accommodative monetary policy, the Canadian recovery was on track.
“We’ll get there and it will be a very good thing for Canada,” she said.
Wilkins said the bank has the tools to bring inflation back to target if potential output growth turns out to be lower than anticipated, though she refrained from suggesting which way rates might move in the near term.
The central bank cut overnight rates to 0.75 percent in January and markets see a more than 60 percent probability it will lower rates by another 25 basis points next month.
“Overall a quite dovish speech, but there’s no hint in terms of ‘will we, or won’t we, cut again?’” said Avery Shenfeld, chief economist at CIBC World Markets.
The Canadian dollar weakened following the remarks.
Taken with comments from Governor Stephen Poloz earlier on Thursday that he has not been talking down the Canadian dollar, investors should look for another rate cut in March, said Benjamin Reitzes, senior economist at BMO Capital Markets.
Wilkins said the drop in the price of oil, a major Canadian export, would be felt across the country. The fall in oil revenues will be large and is already occurring, she said. The central bank expects capital investment in the oil and gas sector to fall by about 30 percent in 2015. (Editing by Peter Galloway and Richard Chang)