Economy hotter than estimated, Bank of Canada says

The Bank of Canada kept its benchmark lending rate at a historic low 0.25 per cent Tuesday, while hinting that policy makers are on closer guard for shifts in the inflation outlook that might force them to rethink their pledge to stay on hold through midyear.

In the statement accompanying Tuesday's decision, Governor Mark Carney and his rate-setting panel acknowledged that growth and inflation have been hotter than policy makers projected in their January forecast, saying the economy's 5-per-cent growth in the fourth quarter was ``spurred by vigorous domestic spending and further recovery in exports."

Also, in a nod to the fact core inflation came in at the central bank's 2-per-cent target in January, sooner than policy makers had anticipated, they sounded a somewhat more hawkish tone on price gains. The central bank said the risks to their inflation outlook are now ``roughly balanced," as opposed to language from previous statements which had said inflation risks were ``tilted slightly to the downside."

The bank also added the word ``current" in its key sentence reiterating Mr. Carney's commitment to keep borrowing costs at their record-low level, suggesting the next decision on April 20 could mark the beginning of the end of easy money as the central bank prepares to lay out how it plans to tighten in the second half of the year.

While few economists expect Mr. Carney to raise interest rates before that commitment runs out, recent data and the current statement suggest there is more pressure on the bank to consider unleashing a series of rate hikes over several decisions starting in July, or raise rates more steeply than the typical 25-basis point moves.

``Carney and Co. are starting to feel the urge to tighten, not a strong urge now, but an urge nevertheless," Michael Gregory, a senior economist with BMO Capital Markets, said in a note to clients. ``We still judge that the Bank will hike rates 25 basis points on July 20, with rising risks that this and/or subsequent moves could be in larger increments.''

Core inflation has been ``slightly firmer" than expected, the bank said, as a result of ``both transitory factors and the higher level of economic activity." The reference to ``transitory factors" likely refers to recent gains in prices for automobiles such as trucks, which don't seem sustainable, and housing prices.

``Conditional on the current outlook for inflation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010 in order to achieve the inflation target," the bank said.

Policy makers also dropped a reference to the central bank retaining ``considerable flexibility" in using monetary policy to cement the economic recovery. That suggests measures such as so-called quantitative easing, which involves creating new money to purchase government or private assets in a bid to encourage more bank lending - a step taken by other major central banks around the world but not Canada's.

At the same time, the bank said the inflation outlook should not only continue to reflect ``stronger domestic demand," but also ``slowing wage growth, and overall excess supply." And Mr. Carney and his deputies repeated that ``persistent strength of the Canadian dollar and the low absolute level of U.S. demand continue to act as significant drags on economic activity in Canada."

Central bankers have said the economy won't be running at full tilt until the second half of 2011. However, the January inflation data, released last week, and Monday's gross domestic product report from Statistics Canada suggest the slack in the economy may be disappearing more quickly than the bank projected in January.

The April 20 rate decision is also important because it will offer the first taste of the Bank of Canada's next economic forecast, due two days later.

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Even central bank-watchers who have argued Mr. Carney won't raise rates until the final three months of the year at the earliest are now saying the bank could act with more urgency.

``The Bank of Canada has walked a fine line with its latest decision, though overall it is undeniable that the risks to Canadian monetary policy are starting to tilt upwards," Eric Lascelles, top rates strategist for TD Securities, said in a note. ``Our house view remains that the Bank of Canada will first hike in October, but it is hardly inconceivable that this could now come a touch sooner, in September or possibly even July."