Bank of Canada holds fast on rates

The Bank of Canada has announced it will maintain its target for the overnight rate at 1%, holding the Bank Rate at just 1.25% and the deposit rate at 0.75%.

While the global economic recovery is largely unfolding as expected, the Bank cited slower than anticipated growth in the U.S. as a concern.

The Bank acknowledged that inflationary pressures are building, pointing to surging demand for raw materials in emerging markets.

“These high prices, combined with persistent excess demand in major emerging-market economies, are contributing to broader global inflationary pressures,” the Bank said in a press release.

At home, household spending and business investment continue to show strength, but the export sector remains “weak,” the Bank said, reflecting “ongoing competitiveness challenges, particularly the persistent strength of the Canadian dollar”.

And therein lies the primary reason for holding rates low. While the Bank’s primary mission is to manage inflation, raising rates ahead of a similar move by the U.S. Federal Reserve would further harm the export-dependent manufacturing sector.

The Bank’s statement did include hints that rates could rise in September, however. It blames slow second quarter economic activity on supply chain disruptions—notably the disasters that struck Japan in March. But these problems have already worked their way through the system, and the economy is poised to “re-accelerate in the second half of 2011”.

“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in the economy is gradually absorbed, some of the considerable monetary policy stimulus currently in place will be withdrawn, consistent with achieving the 2% inflation target,” the Bank warned. “Such reduction would need to be carefully considered.”

This was enough of a warning for CIBC chief economist Avery Shenfeld.

“The clock is running out on ultra-low interest rates in Canada. In dropping the word ‘eventually’ that it had previously used in discussing the timing for future interest rate increases, the Bank of Canada gave a not-too-subtle hint that it expects to begin that process before year-end,” he wrote in a commentary on the rate announcement.

Shenfeld predicts the Bank will raise rates by 25 basis points in October, but admits a September rate hike remains a possibility.

“Look for the Canadian dollar to trade near the stronger end of its recent trading range as we gradually price in the reality of wider interest rate differentials vs. the US,” he wrote. The impact of today’s release on the bond market should be to exert upward pressure on short-term yields if third quarter growth unfolds as anticipated and justifies the next round of rate hikes.

Inflation continues to worry the Bank, as total CPI is now expected to remain above 3% in the near term. Core inflation is currently “slightly firmer” than expected, but is expected to return to the Bank’s 2% target by mid-2012.

Overall, the Bank projects growth of 2.8% in 2011, 2.6% in 2012, and 2.1% in 2013, returning to capacity in the middle of 2012.

All of this assumes that the ongoing European sovereign debt crisis is contained, but the Bank admits “there are clear risks around this outcome”.

The next scheduled date for announcing the overnight rate target is September 7, 2011.

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