Hot off of the press of the Financial Post

Bank of Canada raises rates

Paul Vieira, Financial Post * Wednesday, Sept. 8, 2010

OTTAWA — The Bank of Canada raised its benchmark interest rate
Wednesday by 25 basis points to 1%, arguing financial conditions remain
“exceptionally stimulative” even in the face of a slowing — but still
growing — economy.

In its accompanying statement, the central bank acknowledged the
economic recovery in Canada would be “slightly more gradual” than
envisaged it its most-recent economic outlook, due to sluggish
private-sector demand in the United States. However, it said domestic
demand was expected to be “solid” and business investment to advance
“strongly” — powered by “accommodative” credit conditions that have
eased further in recent weeks due to sharp declines in bond yields.

Banks price loans, such as mortgages, based on yields for relatively
safe government debt.

The statement provided no suggestion the central bank was set to keep
rates on hold for an indefinite period, as some analysts now expect.

“As a result of monetary policy measures taken since April, financial
conditions in Canada have tightened modestly but remain exceptionally
stimulative,” the central bank said.

For instance, consumers continue to take out loans at a steady pace,
with central bank data suggesting household credit expanded at an
annualized 7.1% pace for the three-month period ended July 31.

The Bank of Canada said future hikes in its key lending rate, up 75
basis points in the past three months, “would need to be carefully
considered in light of the unusual uncertainty surrounding the outlook.”

This decision may come as a bit of a surprise for traders, who have been
largely divided as to which way Mark Carney, the central bank governor,
and his colleagues would lean toward in the face of slower than
anticipated economic growth. Markets had priced in a roughly 60% chance
of a rate hike, and those odds increased over the past week from a less
than 50-50 chance based on better-than-expected manufacturing and labour
data in the United States.

Canadian GDP expanded 2% annualized in the second quarter, well below
the central bank’s forecast of 3%. However, analysts have said the
economy was stronger than the headline print indicated, as final
domestic demand advanced at a robust pace (3.5%). Plus, much of the drag
in the second-quarter was from so-called “import leakage,” in which
gains in imports — as firms acquired productivity-enhancing equipment
at the fastest pace since 2005 — outstripped exports.

Of the GDP results, the Bank of Canada said economic activity “was
slightly softer” than expected, “although consumption and investment
have evolved largely as anticipated.”

The central bank is likely pleased at the turnaround in business
investment, which it has argued is required for the recovery to maintain
momentum once consumer spending tapers off. Plus, investment from firms
in productivity-enhancing technology is required to ensure future
growth.

The bank said the Canadian recovery would be “slightly more gradual than
it had projected in July … largely reflecting a weak profile for U.S.
activity.” The U.S. Federal Reserve has said it was prepared to take
further action if required to stoke the recovery, although officials at
the powerful central bank are unsure such measures are required.

The Bank of Canada said inflation — which the central bank aims through
rate decisions to hit and maintain a 2% level — has been “broadly in
line” with expectations and “its dynamics are essentially unchanged.”

In terms of the global picture, it said the recovery is proceeding “but
remains uneven, balancing strong activity in emerging market economies
with weak growth in some advanced countries.” As for the United States,
the world’s biggest economy and Canada’s biggest trading partner, the
central bank said the recovery in private demand is “being held back by
high unemployment and recent indicators suggest a more muted recovery in
the near term.”

Economists have scaled back growth expectations for both Canada and the
United States, although at the same time boosting the forecast for
Europe as its major economies are advancing better than expected
following the sovereign debt crisis in the spring.

The central bank is scheduled to provide an updated economic outlook
next month, two days following its next rate decision on Oct. 19.
Previously, the central bank had forecast 3.5% economic growth this
year, followed by 2.9% expansion in 2011. The output gap — a rough
measure of the amount of excess capacity in the economy — is expected
to close by the end of 2011.