Bank of Canada holds firm on interest rates, for now

OTTAWA - The Canadian dollar jumped nearly 1.5 cents Tuesday after the Bank of Canada issued its first unambiguous warning that it is preparing to raise interest rates.

The central bank's policy statement Tuesday surprised no one by keeping the trend-setting interest rate at the record low 0.25 per cent for another announcement date, but it was clear about where it was heading next.

The bank's governing council declared that with the economy and inflation growing faster this year than had been previously thought, there was no need to stay with its "conditional commitment" to leave rates unchanged until the end of the second quarter, or after June 30.

"This unconventional policy provided considerable additional stimulus during a period of very weak economic conditions," the council wrote.

"With recent improvements in the economic outlook, the need for such extraordinary policy is now passing, and it is appropriate to begin to lessen the degree of monetary stimulus."

Hence, the council went on, it was withdrawing the conditional commitment.

The bank also said it was ending its key emergency lending instrument that helped inject liquidity in money markets during the crisis, which economists called a clear signal about the central bank's future intentions.

"Removing the conditional commitment to keep rates on hold until July and ending purchase and resale agreements are as good as cementing a June 1 hike," said economists Derek Holt and Karen Cordes Woods of Scotia Capital.

"That leaves open the debate over whether (a hike of) 25 basis points or 50 basis points is likely."

The loonie soared immediately after the 9 a.m. EST release, rising 1.52 cents to slight above parity with the American greenback.

Markets had already been planning for the central bank to move off emergency rates and in the past few weeks had begun raising fixed, longer-term mortgage rates.

Once the bank does act, short-term rates and variable mortgages are also likely to be increased.

But the dollar's strong move suggests the hawkish tone in the statement was not all priced in.

"Simply put, this statement marks a dramatic change in tone by the bank, and doesn't rule out possible 50 basis point moves," said Douglas Porter, deputy chief economist with BMO Capital Markets.

Several economists had been urging governor Mark Carney to move early on interest rates, but the vast majority felt the bank would lose credibility if it did so without a clear indication that inflation was getting out of control.

A small minority, however, argued that the economy was still too weak to warrant any increase in interest rates this year, and that doing so could stall the recovery.

Economists also feared that an early signal from the bank, ahead of the U.S. Federal Reserve, would light a fire under the loonie and make life even more difficult for Canada's battered manufacturing and export sector.

The bank gave at most a mixed signal that it believes inflation is getting out of hand, however, it said it was more lively than it had expected.

Nor is the economy in danger of overheating, judging by the bank's new forecasts for 2010, 2011 and 2012.

The bank said the economy will advance 3.7 per cent this year, 3.1 per cent next year and 1.9 per cent in 2012. In January, its last forecast, it had growth at 2.9 this year, 3.5 next and gave no estimate for 2012.

In essence, the bank has moved up its estimate for growth in the near term but left it relatively unchanged in the aggregate.

"This profile reflects stronger near-term global growth, very strong housing activity in Canada, and the bank's assessment that policy stimulus resulted in more expenditures being brought forward," it said.

"At the same time, the persistent strength of the Canadian dollar, Canada's poor relative productivity performance and the low absolute level of U.S. demand will continue to act as significant drags on economic activity," it added.

As for inflation, the council said core prices have been firmer than projected, but that they were expected to ease slightly in the second quarter of this year and remain near the bank's two per cent target over the next two years.

Total headline inflation, which includes volatile items such as gasoline prices, was expected to be higher than two per cent this year, but returning to target in the second half of 2011.

The sum of the parts, the bank said, is that the economy will return to full capacity one quarter sooner than it had previously thought in the second quarter of 2011.