Bank of Canada warns higher rates ahead

The Canadian dollar posted its biggest single-day gain since July Tuesday as the Bank of Canada warned that it will be raising interest rates.

The dollar closed up 1.58 cents to 100.12 cents US.

The Bank of Canada kept its key lending rate unchanged Tuesday, but warned that its low-rate policy has a limited future.

The bank held the overnight rate at 0.25 per cent, as economists had expected.

But with the economy recovering and inflation running above the bank's two per cent target, the need for rock-bottom lending rates "is now passing," it said in a statement.

The extent and timing of any change in the key rate "will depend on the outlook for economic activity and inflation," the bank said. The bank also noted growth is "proceeding somewhat more rapidly" than it expected earlier this year, increasing the chance of a rate rise in the early summer.

"Simply put, this statement marks a dramatic change in tone by the bank, and doesn't rule out possible 50 basis point moves," said Douglas Porter, deputy chief economist with BMO Capital Markets, in a commentary.

Porter predicted a June rate hike is now "likely," adding that the central bank is clearly much more concerned about inflation than previously indicated.

The bank sets a target level for the overnight rate, which is often called the key interest rate or key policy rate because it indicates the bank's thinking about the economy.

'Simply put, this statement marks a dramatic change in tone by the bank, and doesn't rule out possible 50 basis point moves.' —Douglas Porter, BMO Capital Markets

The overnight rate is the interest rate major financial institutions charge each other for one-day loans.

The rate has been at a very low 0.25 per cent since April 2009, when it was cut from 0.50 per cent as the recession worsened. It was at a recent peak of 4.5 per cent in October 2007.

The bank's "extraordinary policy" of ultra-low rates was introduced to boost the recovery, the statement said.

The bank is forecasting growth of 3.7 per cent this year, reflecting stronger global activity, strong housing activity in Canada and the bank’s conclusion that policy stimulus advanced some spending into late 2009 and early 2010.

It's forecasting that Canadian economic growth will slow to 3.1 per cent in 2011 and 1.9 per cent in 2012.

Competing pressures

Bank governor Mark Carney is juggling competing pressures: the need to control inflation with a higher rate; the need to keep the cost of loans low to encourage business and consumer borrowing; and the strong dollar.

A bank rate increase could push the dollar even higher, hurting exports and jobs. While recognizing that growth is strong, the bank warned Tuesday about economic negatives: "the persistent strength of the Canadian dollar, Canada’s poor relative productivity performance and the low absolute level of U.S. demand."

Although Carney expressed concern about inflation in March, the bank said it is expecting the rate to ease slightly in the second quarter, and remain slightly above the target two per cent rate this year before easing in the second half of 2011.