Bank of Canada upgrades forecasts; opens door to June rate hike by removing conditional commitment

The Bank of Canada left the overnight rate at 0.25% this morning and opened the door to rate increase at the June meeting by removing its conditional commitment to keep the policy rate at its current level, "until the end of the second quarter of 2010." The Bank stated that 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 extent and timing will depend on the outlook for economic activity and inflation, and will be consistent with achieving the 2% inflation target."

The change in the Bank's statement reflected a sharp upgrade to the Bank's economic forecast with growth in 2010 forecasted at 3.7%, up from 2.9% in its January projection. The 2011 growth forecast was revised lower to 3.1% from the 3.5% growth rate in their January outlook. The Bank added its 2012 forecast for the economy to expand by 1.9%, which we assume is its estimate of the economy's potential. As a result of the faster pace of growth in the near term, the Bank expects that the economy will reach its productive capacity and inflation to the 2% target in the middle of 2011, sooner than was thought in January. The Bank failed to provide an overall assessment of the risks to the outlook based on macro considerations, which is unusual, but it clearly acknowledged that some reduction in the amount of policy stimulus will be required over time. The pace of which will depend on the flow of data. To our mind, the Bank will be cuing the timing of its first rate hike off of upcoming inflation reports looking at movements in the core inflation data which are forecasted to "ease slightly in the second quarter of 2010."   

The upgrades to the 2010 economic forecast were based on recently strong housing market activity and global growth as well as the Bank's assessment that policy stimulus supported, "more expenditures being brought forward in late 2009 and early 2010."  The statement also sited uncertainty about the pace of the global recovery combined with the potentially restraining effect of the strengthening in the Canadian dollar and low productivity as downside risks for the economy going forward.

Today's statement sets up interest rates to start to rise, with the first increase likely to be dictated by movements in the core inflation rate, assuming that the economy continues to show strong growth momentum as we (and the Bank) expect. We forecast that the core inflation (to be released on Friday) will show an easing in the Bank's core rate to 1.8% as the jump in travel accommodation prices proves transitory and remains below 2% in April, which will ease the pressure for a June rate hike. Today's statement, however, leaves the door open to the Bank moving rates in June. Today's rate decision and statement reinforce our view that economic conditions are strong enough that the Bank will increase the overnight rate and there is risk that the first hike comes in June rather than July. Our forecast is that the Bank will raise the policy rate to 1.25% in 2010, and the pace of tightening will accelerate in 2011 as the economy continues to build momentum with the overnight rate finishing the year at 3.5%.  

Dawn Desjardins, Assistant Chief Economist, RBC Economics