OTTAWA — A global hunger for Canadian resources, coupled with strong domestic demand, is fuelling robust growth that may require higher interest rates to cool down the economy, says the Bank of Canada.
In its latest monetary policy report Thursday, the central bank forecast that Canada’s gross domestic product will expand by 3.1 per cent this year and it has nudged up its forecast to three per cent growth for 2007, from a previous prediction of 2.9 per cent. The pace will slow only slightly to 2.9 per cent in 2008.
While prices are rising only modestly now, higher interest rates may still be needed to keep inflation in check, the Bank of Canada warned.
As the Canadian economy expands “at or just above its production capacity” more interest rate increases may be needed to keep inflation from boiling over, the report said.
“In line with the bank’s outlook … some modest further increase in the policy interest rate may be required to keep aggregate supply and demand in balance and inflation on target,” said Bank of Canada governor David Dodge.
For now, however, the bank judges its current policy interest rate of four per cent to be “appropriate at the moment, given the economic conditions,” Dodge added during a news conference.
While Canada is growing strongly, helped by the booming energy economy in western Canada, even more robust growth is forecast for the United States, which should fuel continued demand for Canadian exports from its largest trading partner.
GDP growth in the United States is expected to average 3.5 per cent this year, moderating to 3.2 per cent in 2006 and 3.1 per cent in 2007.
Dodge’s comments come only two days after the Bank of Canada raised its key policy interest rate to four per cent, its sixth consecutive quarter-point increase. That has narrowed the gap with the U.S. Federal Reserve’s benchmark interest rate of 4.75 per cent.
Analysts have noted the Bank of Canada’s recent softer wording on possible rate hikes — a significant change from previous statements that more forcefully warned that higher borrowing costs would be needed.
The less direct wording has split financial market watchers in recent weeks over whether the central bank intends to raise rates at least one more time or whether it feels conditions now are tight enough to keep a lid on inflation.
Core inflation, which is most closely watched by policy-makers and excludes some volatile food and energy prices, is expected to rise to an average two per cent in the second half of this year, a bit sooner that previously expected.
Driven up by higher electricity costs, the core rate is expected to remain for the next two years at two per cent, right where central bankers like it.
Prospects for higher Canadian interest rates pushed up the Canadian dollar by 0.43 of a cent to 89.04 cents US by midday Thursday — a fresh 14-1/2-year high.
In a report Thursday, TD Bank said the Bank of Canada’s more hawkish tone on inflation likely means another quarter point interest rate increase at the central bank’s next meeting May 24.
“In our opinion, unless there is significant increased pass through from elevated energy prices, inflation is likely to remain subdued,” the bank said. “This is why we believe that the bank should leave rates on hold.”
The central bank adjusts interest rates to keep inflation under control in a growing economy — no easy feat, particularly when high energy prices are expected to create volatility in the overall inflation rate.
That rate was tame in March at 2.2 per cent, but analysts have warned that a new spike in oil prices is bound to drive up the total cost of living in April and beyond.
However, central bankers say they don’t expect that higher costs to spill over into the core measure of inflation, which averaged 1.7 per cent last month.
Offsetting high and volatile energy costs is the reduced price of imported goods, thanks to the strong Canadian dollar.
As well, the minority Conservative government’s plan to cut the federal goods-and-services tax by one percentage point to six per cent, from seven per cent, in next week’s federal budget will also hold down overall inflation.
The tax cut could shave about 0.6 of a percentage point off overall inflation for one year only and wouldn’t affect the closely watched core rate, the central bank suggested.
Booming global growth should average 4.8 per cent this year — up from the previous four per cent forecast — slowing to 4.6 per cent in 2007, thanks to remarkable growth in China and other parts of Asia, the central bank says.
Still, the strong loonie has held back the export sector, leaving a strong domestic demand to keep the economy afloat.
Housing investment will likely rise “a little further” this year but ease a bit in 2007 and 2008 as higher interest rates begin to bite.
Still, the central bank has been “a little bit surprised” by the continued strength of the housing market despite the rise in interest rates, said Dodge. “And we will be watching the effects of past increases …particularly closely.”
