Bank says it will raise rates if economy continues to expand as expected

OTTAWA -- The Bank of Canada has signalled that interest rates will likely rise later this year, as long as the still-fragile economic recovery continues to build.

For the sixth straight announcement date the central bank on Tuesday delayed the tightening regime it had begun almost a year ago to the day and kept its trendsetting policy interest rate at one per cent. But in an accompanying statement, the bank did alter its advisory on future action, indicating it will start moving rates closer to their normal levels if the recovery continues on track.

"To the extent that the expansion continues and the current material excess supply in the economy is gradually absorbed, some of the considerable monetary policy stimulus currently in place will be eventually withdrawn,'' it said.

"Such reduction would need to be carefully considered.''

It's the first time the bank has signalled in an interest rate announcement that it will eventually have to raise rates, although governor Mark Carney has been warning Canadians in speeches and news conferences that higher rates are coming for more than a year.

Financial markets appeared to react to the new language -- the loonie jumped nearly a cent to 103.28 cents US following release of the statement at 9 a.m.

But analysts also said nothing was carved in stone.

The bank's ambiguous phrasing in adding "carefully considered'' to its signal of monetary tightening, said CIBC chief economist Avery Shenfeld, puts the odds of a move in July at less than 50 per cent. He predicted the bank will begin tightening in September -- about where most economists were prior to the announcement -- with the overnight rate being raised to 1.75 per cent by the end of the year.

Another analyst, Scotiabank's Derek Holt, said he was sticking to his prediction of an October restart date but recognized that Carney would feel the need to signal that ultra-low rates would not be around forever.

The markets were starting to think that the Bank of Canada had already given up on this year for moving rates north, and Carney wanted to disabuse investors of the notion, Holt said.

"In the last few weeks we'd seen markets move toward taking out any expected Bank of Canada moves at all this year and I think the bank was getting a little uncomfortable with that.''

Holt said the bank seems to be as uncertain about how the recovery will unfold as is most of the world. Policy-makers, including Carney, have of late taken to setting off warning flares about rising risks to the world economy, although the tone in the bank's statement was less alarmist this time.

The bank statement Tuesday appeared to take a slightly darker view of the modest nature of the U.S. recovery and the European debt crisis than it did in April, while repeating its concerns about Japan's dual natural and nuclear disasters

But it continued to say that the global recovery is proceeding broadly as outlined in its last policy review, and so is Canada's. While supply chain disruptions emanating from Japan will cause Canada's second-quarter growth to fall sharply, the negative impacts will be short-lived.

"Although temporary supply chain disruptions are expected to restrain growth sharply in the current quarter, this is expected to be unwound in subsequent quarters,'' the bank reasoned.

As well, Carney remains convinced that inflation pressures caused by high commodity prices are a temporary phenomenon, at least in Canada.

"The bank expects that high energy prices and changes in provincial indirect taxes will keep total CPI inflation above three per cent in the short term,'' it says. "Total CPI inflation is expected to converge with core inflation at two per cent by the middle of 2012 as excess supply in the economy is gradually absorbed, labour compensation growth stays modest, productivity recovers and inflation expectations remain well-anchored.''

The risk to higher inflation is that household borrowing grows, given low rates, but on the other hand, the bank says, the strong Canadian dollar should keep prices of imports in check.

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