June 23, 2017 / 7:16 PM / 2 months ago

Low inflation problematic, but will not sway hawkish Bank of Canada

OTTAWA, June 23 (Reuters) - Unexpectedly cool Canadian inflation data released on Friday make it hard for the Bank of Canada to justify hiking interest rates in the next month or two, but analysts expect policymakers to stay hawkish amid concern that rates have been low too long.

While senior bank officials shifted tone last week to make it clear rate hikes are in store, the annual inflation rate declined to 1.3 percent in May and price pressures remain well below the bank's 2 percent inflation target.

Still, economists expect the bank will follow the Federal Reserve's example and raise rates before inflation proves tighter policy is needed - even if such a move appears to go against their inflation-targeting mandate.

"I think it's a conundrum for them," said Mark Chandler, head of Canadian fixed income and currency strategy at Royal Bank of Canada.

With the U.S. Federal Reserve and Bank of England among central banks tightening or biased towards a hike, Chandler believes global policymakers are responding to shared concerns that low rates may have caused financial instability.

The prospect of a strong Business Outlook Survey, to be released June 30 by the bank, may also have spurred the more hawkish tone, said Chandler who expected it to echo exporter optimism reported this week in Export Development Canada survey.

While markets have priced in a hike before the end of the year, Friday's low inflation reading reduced the likelihood of a July hike to 22 percent from 35 percent before the report was released. The bank has held rates at 0.50 percent since 2015.

CIBC Capital Markets economist Nick Exarhos expects a rate hike in October and again early in 2018.

While core inflation numbers and three of the bank's preferred inflation measures are all subdued, Exarhos said service sector inflation is running closer to 2 percent or 2.5 percent, suggesting made-in-Canada price strength.

"Service sector inflation tends to lead the turn and it's been pushing up," he said. "Services are produced inside Canadian borders, so price pressures are driving inside our borders ... and that's seen as a signal of less slack in the economy." Exarhos said Canada, like the Fed, wants to start hiking early enough that the increases can be gradual once the economy reaches full capacity - an approach Senior Deputy Governor Carolyn Wilkins likened in a speech last week to a driver "letting up on the gas" before braking for a stop light.

Still, not everybody sees a 2017 rate hike. Having signaled tightening is in store, policymakers have reduced the incentive for excessive risk-taking and can wait to ensure inflation is in the pipeline before they actually make a move.

"We believe they will wait, but with a hawkish stance," said Carlos Capistran, head of Canada-Mexico economics for Bank of America Merrill Lynch. "They are really in a place where they could go both ways without hurting credibility." (Reporting by Andrea Hopkins)

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