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.
Charles St-Arnaud, Canadian economist and currency strategist at Nomura Securities International, estimates the neutral rate at around 4 percent and said the bank’s guidance meant rates could be 2 percent or 3 percent by mid-2012.
“It doesn’t mean it will stay at 1 percent until then and that’s one of the mistakes the market has been doing lately, and I think they’re gradually understanding that,” he said.
The bank does not say what it considers to be the normal long-run rate, although Carney called the current level “exceptionally stimulative.”
Following the comments, market players saw slightly decreased chances of a rate hike later this year, according to overnight index swaps, which trade based on expectations for the key central bank policy rate.
The Canadian dollar rose to as high as C$0.9457 to the U.S. dollar, or $1.0574, just after the MPR was released from C$0.9485 earlier. It later slipped slightly but held near 2-1/2 month highs.
In its new projections, the bank cut its second-quarter growth forecast to an annualized 1.5 percent, from 2.0 percent, and said core inflation would rise to 2 percent two quarters earlier than previously anticipated, by the end of this year.
But it kept the medium-term outlook largely unchanged, saying the second-quarter slump in growth will be offset by growing faster than expected in the following three quarters.
On external factors, Carney sounded far more worried about potential contagion from the European sovereign debt crisis than he did about the political wrangling in the United States over the debt ceiling.
The European crisis along with continued strength in the Canadian dollar are keeping Carney cautious.
“We are in an environment here in Canada where there are substantial external headwinds,” he said. “In that environment, the bank has to make a judgment in terms of the appropriate path for our monetary policy rate.”
The bank assumes the United States will not default on its debt and that the European debt problem will be “contained” but not necessarily fully resolved, saying Canada is “doing what we can, both bilaterally and through the IMF and other channels, to assist.”
Additional reporting by Solarina Ho, Ka Yan Ng, Claire Sibonney and Trish Nixon in Toronto; writing by Louise Egan; Editing by Jeffrey Hodgson and Rob Wilson