Bank of Canada stays with low interest rate policy

OTTAWA -

The decision Tuesday to keep the policy rate at one per cent came despite a mostly upbeat assessment of the Canadian economy from the central bank that predicts faster growth and a quicker return to full capacity.

The bank's next scheduled date for an interest rate announcement comes May 31.

Meanwhile, it said the economy will grow at 2.9 per cent this year, half a point faster than it estimated in January. As well, the economy will return to full capacity in just over a year, six months earlier than previously thought.

Despite the improved outlook -- which brings the bank in line with private sector economists and recent strong economic indicators -- that bank chose to highlight the pitfalls to the recovery, which appear to be growing with each report.

Globally, high commodity prices are igniting inflationary pressures, while the earthquake and tsunami disaster in Japan are disrupting supply chains. Meanwhile, Europe still faces debt and banking challenges and the U.S. is beset by both government and household debt.

In Canada, the bank twice cited concern that the high-flying loonie is eating away at exports, a strength in the economy.

"The persistent strength of the Canadian dollar could create even greater headwinds for the Canadian economy, putting additional downward pressure on inflation through weaker-than-expected net exports and larger declines in import prices," it said.

Coincidentally, a trade report from Statistics Canada issued some 30 minutes before the bank's announcement served to prove the bank's fears.

Coming off recent strong numbers, Canada's merchandise trade surplus fell to $33 million in February as exports dropped 4.9 per cent in value terms, and 5.2 per cent in volume terms.

Economists said they were somewhat surprised by the bank's cautionary approach, and grudging concession that it had been much too pessimistic in its previous assessment.

"It was a little less hawkish and strident than we were expecting," said Douglas Porter of BMO Capital Markets. "There's certainly no sign here the bank has got itchy fingers."

Scotiabank economist Derek Holt said he still expects the bank to hold current interest rates until October, although most analysts see July as when the bank will begin making its first moves toward taking the policy rate to what is considered normal levels above three per cent.

Porter notes that if the central bank is correct that the economy will return to full capacity in just over a year's time, it doesn't give governor Mark Carney much time to triple the policy rate.

But Holt lists a number of reasons why rates might stay lower longer than normal circumstances might dictate.

Although the bank has upgraded growth this year, it still expects economic expansion to slow next year to 2.6 per cent and to 2.1 per cent in 2013.

Meanwhile, there are the perils of a strong loonie, which would likely rise even further if bolstered by higher rates. And, although the capacity gap is narrowing fast it is unlikely to trigger inflation, which remains in check.

"All told, this is the correct tact," Holt said of the bank's position. "Canada is not showing European- or Asian-style price pressures, full stop. Analysts commenting to the contrary must be looking at another country's data."

In fact, the Bank of Canada makes a point of noting that it expects wage growth to remain modest going forward.

The bank will release a more detailed explanation of where it sees the economy going on Wednesday.

In Tuesday's abbreviated statement, the bank said business investment will be a key strength in the economy and that thanks to the wealth effects from Canadian exports of high-value commodities, consumer spending may remain more sprightly than otherwise expected.

Exports have improved, it adds, but they will be weighed down by the strong currency, which makes Canadians products more expensive in foreign markets. Also restraining growth are efforts by governments to rein in deficits.

While it believes the global and Canadian recoveries are becoming more entrenched, the bank also makes clear that there are plenty of traps out there that could upset the apple cart. The global economy also has some momentum, however, it added.

"Despite the significant challenges that weigh on the global outlook, global financial conditions remain stimulative and investors have become noticeable less risk averse," the bank said.