Canada: The Inflation Hawks Are Circling

The Bank of Canada has served notice. Unexpectedly strong inflation and an economy closer to its productive capacity than previously thought mean higher interest rates ahead.

At its Jan. 21 meeting, the BOC kept rates at 2.75% but took a more hawkish stance. After hiking rates by 75 basis points last year, Governor David Dodge said "a reduction in stimulus will be required" to bring inflation back to its 2% target. The central bank now thinks inflation won't hit that target until early 2004.

The BOC's concerns were not assuaged by the news that consumer prices in December were up 3.9% from the year before. While less than the 4.3% November rise, the slowing came largely from a one-time change in Ontario electricity pricing. Core inflation, the BOC's preferred measure, which strips out volatile items such as fresh produce, gasoline, tobacco, and mortgage interest costs, also slowed to 2.7% from 3.1%.

Indeed, some deceleration in inflation in 2003 is expected. One-time events such as recent hikes in auto and home insurance premiums should come to an end.

The economy is slowing, too. Fourth-quarter real gross domestic product probably rose at a 2% annual rate, as indicated by weak retail sales and factory inventories. And the current quarter may be weaker still. Softer demand should curb broader price pressures in the short term.

But the BOC doesn't want to get behind the curve. It attributes the slipping economy to uncertainty over Iraq and other geopolitical risks and believes they will be largely resolved by midyear. So by the second half, price pressures could build as demand picks up at home and in the U.S., destination of 87% of Canada's exports.

For now, economists see a rate hike in June. But the BOC has warned that business expectations of higher inflation may affect wage deals and other decisions. If that happens, "the need for policy action by the Bank would be correspondingly greater," the BOC says, suggesting earlier moves.

By James Mehring in New York

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