Bank of Canada Says Economy Growth to Slow on Strong Dollar

The Bank of Canada said economic growth will slow after a burst at the start of the year, with auto production hampered by Japan’s earthquake and exports curbed by a strong dollar.

The economy will grow at a 2 percent annualized pace in the April-June period following a 4.2 percent expansion in the first quarter, the Ottawa-based central bank said in its Monetary Policy report. Gross domestic product will grow at a 2.7 percent rate in the second half of 2011, the report said.

“One of the most important factors at the moment are the strong headwinds that the Canadian economy is experiencing now and will in the future from the persistent strength of the Canadian dollar,” Governor Mark Carney said at a press conference in Ottawa today.

The central bank kept its benchmark rate at 1 percent yesterday, where it has been since September, and reiterated today that further increases would be “carefully considered.” The Canadian dollar last week reached the strongest since November 2007 on higher commodity prices, which make up 45 percent of the country’s exports.

The bank raised its assumption for the Canadian dollar through 2013 to 103 U.S. cents, from its January assumption of parity. The currency was little changed at 96.25 cents per U.S. dollar at 3 p.m. in Toronto. One Canadian dollar buys $1.03896.

‘Onerous’ Exchange Rate

“Before they act, they want to make sure that the economy is doing okay amid what they believe is going to be an onerous level of the exchange rate,” said Michael Gregory, senior economist at Bank of Montreal in Toronto. Increases will begin in July and the policy rate may reach 3 percent by the middle of next year, he said.

Economists at Canadian Imperial Bank of Commerce and Toronto-Dominion Bank also predict a July rate increase. Today’s report reiterated the comment from the central bank’s January report that the projection “includes a gradual reduction in monetary stimulus.”

Canada’s trade balance has moved back into surplus after a record deficit set last July, even as the currency strengthened. The bank reiterated today that Canada’s recovery will be led by exports and business investment, taking over from governments that are ending stimulus spending and consumers with record debt loads.

‘More Modest Pace’

“The expected rebalancing of aggregate demand in Canada has begun, with investment picking up strongly and contributions to growth from government expenditures scheduled to fade,” the report said. “The stronger economic expansion observed in recent quarters is projected to give way to a more modest pace.”

Exports will have a temporary setback this quarter due to automobile-plant shutdowns linked to Japan’s earthquake and tsunami, which will cut Canada’s second-quarter growth rate by half a percentage point, the report said. Output was “about 1 percent” below full capacity in the first quarter, the bank said.

The economy was a focus of televised leadership debates last night in the May 2 election campaign. Prime Minister Stephen Harper said he needs a majority government to complete the economic recovery, while Liberal Leader Michael Ignatieff said the government’s corporate tax cuts will squeeze funding for social programs such as health care.

Reduced government spending will slow the economic growth rate by 0.2 percentage point this year and by 0.6 percent next year, the bank said.

Growth Forecast

The report echoed the bank’s announcement yesterday raising its 2011 growth forecast to 2.9 percent from 2.4 percent and cutting its 2012 forecast to 2.6 percent from 2.8 percent. The bank also advanced the date when the economy should return to full capacity by six months to the middle of next year.

Canada’s expansion will slow further in 2013 to 2.1 percent, the bank projected, equaling the rate the economy can grow without sparking inflation.

The bank sets monetary policy to keep inflation at 2 percent, and policy makers said today the risks to its outlook are “roughly balanced.” Canadian inflation, which was 2.2 percent in February, will peak at 3 percent on a monthly basis this quarter and return to 2 percent in the second quarter of next year. The so-called core inflation rate, which reached a record low 0.9 percent in February, will rise to 2 percent by the middle of next year.

Don’t ‘Miss the Boat’

“It’s kind of surprising to me why they wouldn’t move to prepare the market for rate increases,” said Thorsten Koeppl, economics professor at Queen’s University in Kingston, Ontario, and former researcher at the European Central Bank. The key rate may need to reach a “neutral” mark of 4 percent as the output gap closes, and Carney “has to be really careful he doesn’t miss the boat” on faster inflation, Koeppl said.

Other countries are dealing with greater inflation pressures, the Bank of Canada said today. China’s economy is showing “signs of overheating” with interest rates adjusted for inflation below zero and credit growing 20 percent on a year-over-year basis, the report said.

In emerging markets, “inflationary pressures are building particularly rapidly” because of rising commodity prices, the report said. Monetary policy in many of those countries “remains very accommodative” and adjustments in exchange rates are being delayed with currency and capital controls, the bank said.

“This is a major issue, not just for those economies but for the global economy,” Carney said at the press conference.

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