The Bank of Canada raised its key interest rate to 4.5 per cent, the first increase in more than a year, and said more rate hikes may be needed to dampen inflation. The central bank boosted its overnight lending rate Tuesday from 4.25 per cent, as expected. The move spells higher borrowing costs for consumers who carry a mortgage or use credit cards, business loans and lines of credit.
In a lengthy statement, the central bank said more “modest” increases are likely after inflation topped its expectations. Core inflation, which strips out the most volatile items in the consumer price index, has been running ahead of the bank's 2-per-cent target for the past 10 months.
“We are expecting another 25-basis-point rate hike on September 5 to 4.75 per cent, followed by a brief pause to gauge the effect of both the higher interest rates and the recent appreciation of the Canadian dollar,” said Ted Carmichael, chief economist of J.P. Morgan Securities Canada Inc., in a note.
Tuesday's move is bound to prove unpopular with exporters, which have watched this year's 10.7-per-cent surge in the Canadian dollar with growing alarm.
The central bank, however, is worried that price increases could spiral if it doesn't act. A Bank of Canada survey last month suggested businesses are concerned too. The percentage of firms expecting inflation to be 2 per cent or higher rose to 84 per cent from 70 per cent previously.
“Some modest further increase in the overnight rate may be required to bring inflation back to the target over the medium term,” the bank said in a statement.
The sentence marks a shift in the bank's stance: in its previous statement in May, it said increases would be needed in the “short term” and it didn't use the word “modest” — the new statement thereby suggesting that interest rates aren't poised to soar.
The bank acknowledged Tuesday that both economic growth and inflation have been hotter than it had anticipated in April. Domestic demand has remained “the key driver” of Canadian economic growth, buoyed by strong commodity prices.
“The bank judges that the economy is now operating further above its production potential than was projected” in April, the bank said.
It also noted the Canadian dollar's swift appreciation, saying the currency has moved “well above the trading range” it had projected in the spring. It boosted its projection for the loonie, now saying it will likely trade in the 93-cent ( U.S.) to 95.5-cent range.
It also raised its forecast for Canadian economic growth. It now sees the economy expanding 2.5 per cent this year (from its previous estimate of 2.2 per cent), and to grow “somewhat” more slowly than it had thought next year and in 2009 because of the strong dollar.
“This brings aggregate supply and demand in Canada back into balance in 2009,” it said.
Inflation, meantime, is expected to be “slightly higher and more persistent” than the central bank had thought in April. By early 2009, that should ease as excess demand subsides.
Risks to the economy are now “roughly balanced” in the context of the bank's new projection. The main risk of strength is that household demand in Canada could be stronger than expected. The main risk of weakness in the economy is the strong Canadian dollar and the slowdown in the U.S. housing sector.
The Canadian dollar eased after the report, trading at 94.94 cents (U.S.) from Monday's close of 95.27, a 30-year high.
The bank will give more details on its views on Thursday, when it publishes its monetary policy report update. The central bank's next rate decision is Sept. 5.
