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Bank of Canada sets stage for rate hike

Informative artice by Paul Viera, Financial Post... 

The Bank of Canada scrapped on Tuesday its conditional commitment on interest rates, setting the stage for a June hike if it so chooses.

The move had an immediate impact on the Canadian dollar, as it surged by US1.6¢ to trade just over parity with the U.S. currency, as of 10 AM ET. Bond yields across the board climbed, with the yield on the two-year note hitting a 52-week high.

The decision was unveiled in its latest interest-rate statement, and it marked a “dramatic change in tone” from the central bank, said Douglas Porter, deputy chief economist at BMO Capital Markets.

“A rate hike in June is now very much on the table,” he said, adding that increases of 50-basis-points can’t be ruled out.

The central bank’s reasoning is based on a new hawkish inflation forecast that envisages consumer price increases hovering above the key 2% level over the next 12 months. In its previous forecast, the central bank didn’t expect inflation to hit 2% until the third quarter of 2011 at the earliest. The central bank sets its key policy rate to achieve and maintain 2% inflation.

Further, the economic recovery “is proceeding somewhat more rapidly” than anticipated as consumers took advantage of record-low rates, the central bank said. As such, it has revised upward its growth projection for this year, to 3.7% expansion from its previous 2.9% forecast, and moved up the timing at which time the Canadian economy is expected to hit full potential – now scheduled to happen in the second quarter of next year, as opposed to the third quarter.

These developments led the central bank’s governing council to ditch its conditional commitment on rates, issued roughly a year ago. The pledge was to keep its key policy rate at its lowest-possible level, 0.25%, until July in an effort to pump up the economy. But the commitment was conditional on its forecast on inflation – which has exceeded expectations.

“With recent improvements in the economic outlook, the need for such extraordinary policy is now passing, and it is appropriate to begin to lessen the degree of monetary stimulus,” the central bank said in its statement. “The extent and timing will depend on the outlook for economic activity and inflation, and will be consistent with achieving the 2% inflation target.”

In another stimulus-removing move, the governing council also announced it would cease undertaking special liquidity operations that pump cash into the marketplace. The last such undertaking happened on April 12, and no more are planned. These financing activities were launched at the onset of the financial crisis, to ensure there was enough cash in the system to flow to credit-worthy households and businesses.

Andrew Pyle, wealth advisor and markets commentator with ScotiaMcLeod, said the statement indicated there’s no reason to keep rates at emergency levels any further. “The big question now is how far rates can move before the bank has to release its foot from the brake pedal.”’

However, the market might be getting ahead of itself in terms of its initial reaction to the statement, warned Eric Lascelles, chief Canadian strategist for TD Securities, because risks remain to the bank’s outlook. Further, the central bank will wait for some key data – most notably consumer prices in March, due out Friday – before it settles as to when to raise rates and by how much.

In its last rate statement, on March 2, the central bank took its first steps toward returning the country to more normal rates by signalling a more hawkish tone on inflation and acknowledging the stronger-than-anticipated economy. A few weeks later, Mark Carney, the Bank of Canada governor, delivered a speech in which he emphasized that his rate commitment “expressly conditional,” leading analysts to revisit their outlook and pencil in the possibility of a June increase.

Prior to the Tuesday morning rate announcement, the market had priced in a 33% chance of a June rate hike – down from the 50%-plus odds built into bankers’ acceptance futures last week, according to BMO Capital Markets in a note Tuesday morning. Traders had also anticipated increases in the central bank benchmark rate of up to 125 basis points for the remainder of 2010.

The statement provided some details regarding the revised central bank’s outlook, to be released on Thursday. The forecast period now extends out to the end of 2012, and the biggest change relates to inflation.

Headline inflation is now expected to be “slightly higher” than 2% over the coming year before returning to the 2% target in the second half of 2011. The previous expectation was for inflation to hover below 2% until slowly reaching that mark in the third quarter of 2011.

Meanwhile, core inflation, which strips volatile-priced items such as food and energy, is expected to ease slightly this quarter but remain “near” 2% through to the end of 2012.

Recent data for February suggested core inflation surpassed the 2% level.

Economic growth in 2010 has been bumped up, to 3.7% from 2.9%, but then downgraded to 3.1% in 2011 from the previous 3.5% estimate. The Canadian economy is benefiting from noticeable “momentum” in the emerging markets, whereas the recovery the developed economies remains “relatively subdued” due to overextended household and government balance sheets.

“Despite recent progress, considerable uncertainty remains about the durability of the global recovery,” the statement said.

The Bank of Canada has pencilled in 1.9% growth for that year – a level at which the bank had warned about unless Canadian productivity improved.

“The persistent strength of the Canadian dollar, Canada’s poor relative productivity performance and the low absolute level of U.S. demand will continue to act as significant drags on economic activity in Canada,” the central bank said.

Financial Post

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