Bank of Canada leaves little room to manoeuvre

The Bank of Canada may have painted itself into a corner with its firmly dovish interest rate statement, and some worry an unexpected rise in growth or inflation could force it to take a credibility hit in order to keep prices in check.

The bank's decision to leave its overnight rate unchanged at 4.25 per cent today was expected by the majority of primary dealers, despite recent jobs, growth and inflation data that had suggested to some that more tightening was necessary.

But in stating that current rate levels are "judged at this time to be consistent with achieving the inflation target over the medium term," the bank went against the market's expectations of a more hawkish shift in its language.

The bank noted that Canada's economy is now operating above capacity -- or at a pace where inflation builds -- but said it expected a stronger Canadian dollar and a slowing US economy to rein in growth in 2007 and 2008.

"A lot of the (bank's) justification seems credible, but I think the surprise is that they've seemingly kept themselves boxed in, not really given themselves flexibility if growth and inflation continue to surprise to the high side," said BMO Nesbitt Burns deputy chief economist Doug Porter.

The bank -- which sets policy with the goal of keeping inflation near the midpoint of a 1 per cent to 3 per cent range -- raised rates seven straight times between last September and May, and signaled after the most recent hike that it might be finished.

However, data showing a continued tightening of Canada's jobs market, strong retail demand, and core inflation well ahead of forecasts, had convinced most market participants that the bank would be forced to raise rates once or twice before the year is out.

Many economists who had called for a pause in July admitted to doing so largely because the bank had given no signal in recent speeches that it expected to tighten, a nod to the bank's efforts in recent years to clearly telegraph its moves and not surprise markets.

Any hit to the bank's credibility could lead to increased market volatility, if investors become unsure of the bank's intentions and are forced to guard against being surprised.

"They've really laid themselves out," said RBC Capital Markets senior currency strategist T.J. Marta. "They have been pretty unequivocal here that they're done."

He said the bank may be going out on a limb in suggesting that core inflation will hold at 2 per cent, particularly as the economy faces capacity utilisation pressures and signs build that high fuel costs are seeping through to core prices.

"We're starting to see second-round effects, and it would be hard to declare complete victory over inflation when you've got that going on," he said.

The Bank of Canada faced heavy criticism in 2003 when it was forced to quickly reverse two rate hikes as the economy was hit by the economic effects of an outbreak of Severe Acute Respiratory Syndrome, a rising currency and mad cow disease.

Since then, it has seemed to take a more cautious approach to policy.

On Tuesday, the announcement sent the Canadian dollar to an 11-week low against the greenback, while bond prices rose as dealers took back prior bets that rates would rise.

HSBC Securities strategist Stewart Hall agreed the bank may have limited its flexibility, but noted it sets policy with an eye to a longer-term horizon.

"While the tone suggests they may have not allowed for that much wiggle room, one gets the sense that proving them wrong is going to be a longer term prospect, that month-to-month data doesn't necessarily suggest that they're wrong," he said.

Markets will be looking for more clarity on the Bank of Canada's statement when it releases its Monetary Policy Report Update on Thursday.

As well, the bank's language could put an increased focus on next week's release of June inflation data, as a second-straight month of higher than expected price increases could rattle markets now retracing earlier rate bets.

"(The bank) cannot allow inflation expectations to get out of hand. They can't be seen as laisser-faire as core inflation begins to pick up," said Marta.

- REUTERS