Bank of Canada predicts economic growth in second half of 2011

Bank of Canada governor Mark Carney last week painted a picture of a strengthening Canadian economy, but warned it remained vulnerable to financial storms brewing in Europe.

The central bank’s monetary policy report predicted the economy to bounce back in the last half of the year after a slower-than-expected second quarter, even as risks from a sovereign debt crisis in Europe continue to fester.

“Widespread concerns over sovereign debt have increased risk aversion and volatility in financial markets,” governor Mark Carney said as the central bank released its July monetary policy report. “Although the global outlook remains broadly unchanged, global risks have intensified, most notably in Europe.”

Carney said the bank expects European authorities will be able to contain the crisis, but that still means slower economic growth as governments look to cut spending.

The outlook by the Bank of Canada followed its decision to keep the overnight rate target at one percent, but hinted that as the Canadian economy continues to grow, it will look to raise rates.

Some economists, who noted the bank dropped the word “eventually” in reference to when rates would rise, have speculated that the next rate hike will come in October, while others have suggested the bank will stay on hold until 2012.

The Bank of Canada last raised rates in September 2010.

Carney noted the statement still continued to refer to “some” of the monetary stimulus being withdrawn.

TD economist Sonya Gulati said the governor has made it clear that rates will go higher, but what is unclear is how soon and how fast.

Gulati also addressed his use of the word “eventually.”

“What he’s trying to say is, ‘Don’t take that one word out of the equation and assume that is going to mean it (the rate increase) is going to happen tomorrow,’” she said.

TD expects the Bank of Canada to keep rates on hold until January, when it will start raising rates to two percent, by mid-2012, before pausing to reassess the situation. TD then expects the bank to start raising rates again starting towards the end of next year, reaching three percent in 2013.

The central bank report included a section that described situations where interest rates would remain below historical levels, even when the economy was operating at capacity, if there are significant headwinds.

Carney said the Canadian economy faces “substantial external headwinds,” including a strong Canadian dollar, a sluggish U.S. economic recovery and the turmoil in Europe.

“We have a variety of factors that provide headwinds externally to the pace of the Canadian recovery. In that environment, the bank has to make a judgment in terms of the appropriate path for our monetary policy rate,” he said. “Rates are exceptionally stimulative now, they have been there for a good reason, in an environment of these headwinds — headwinds that we expect to persist.”

BMO Capital Markets deputy chief economist Doug Porter said the central bank was preparing the groundwork for rate hikes later this year.

“However, there is zero indication that the bank is poised to aggressively move on rates, and the rate hike case is built entirely on the assumption that the drama surrounding U.S. and European debt subsides,” Porter wrote in a note to clients.

The Bank of Canada estimated the Canadian economy grew at a pace of 1.5 percent in the second quarter compared with an earlier forecast that looked for growth at a pace of two percent.

However, the central bank said it expected the domestic economy will grow slightly faster in the second half of the year than thought earlier, logging overall annual growth of 2.8 percent for 2011, down slightly from an earlier estimate of 2.9 percent.

 The slower-than-expected growth in the April-to-June quarter was due in part to the end of government stimulus spending, as well as higher food and energy prices that crimped consumer spending in Canada and the U.S.

Added to that was the global economic fallout from the earthquake and tsunami in Japan that disrupted manufacturing supply chains.

The bank estimated that supply disruptions cut roughly three-quarters of a percentage point from GDP growth in Canada in the second quarter.

The bank downgraded its expectations for the U.S. economy — Canada’s largest export market — to 2.4 percent growth for this year, compared with an earlier estimate of three percent in April.

Meanwhile, inflation is expected to come off its recent highs of more than three percent — due in part to energy prices and the effects of the introduction of the HST in Ontario and B.C. last summer — to around two percent by the middle of 2012, the central bank predicted.

The bank noted in its report that core inflation, which excludes some volatile items, is expected to rise slightly higher than two percent for a short time, but remain around two percent over its projection horizon.