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Bank of Canada Keeps Interest Rate Unchanged

The Bank of Canada kept its key interest rate of one per cent unchanged Tuesday and offered no clues as to when hikes might be in the offing.

In its latest decision, the central bank boosted its outlook for 2011 GDP growth by a half-percentage point and signalled economic slack shrank faster than anticipated. But that was offset by increased concern over the elevated Canadian dollar and the impact it might have on net exports, one of two key drivers of economic growth.

"The persistent strength of the Canadian dollar could create even greater headwinds for the Canadian economy, putting additional downward pressure on inflation through weaker-than-expected net exports and larger declines in import prices," it said in its statement explaining its decision to keep its benchmark rate unchanged for a fifth consecutive time.

This rate decision ties in all the economic developments since the last policy statement on March 1 — from the earthquake and subsequent nuclear crisis in Japan to continued geopolitical unrest in North Africa to stellar Canadian data. The statement attempted to strike a balance between positive and negative developments, and offered no hint that the Bank of Canada, led by governor Mark Carney, is ready to pull the rate-hike trigger at its next policy decision on May 31. The decision to stand pat Tuesday was widely anticipated by markets. But the tone of the statement caught some surprised.

"It was not as hawkish as we had thought," said Jonathan Basile, director of economics at Credit Suisse Securities in New York. "There was no shift in policy guidance to indicate a near-term rate move."

The better-than-expected economic indicators, coupled with a global recovery that's becoming "more firmly entrenched," prompted the central bank to revise upward its outlook for 2011 real GDP expansion to 2.9 per cent from its previous 2.4 per cent call in January. On Monday, the International Monetary Fund also pushed up by 50 basis points its estimate for Canadian economic growth this year, to 2.8 per cent. For 2012, the central bank anticipates 2.6 per cent GDP expansion, slightly below its previous 2.8 per cent forecast.

"Aggregate demand is rebalancing toward business investment and net exports, and away from government and household expenditures," the central bank said.

"The bank expects business investment to continue to rise rapidly and the growth of consumer spending to evolve broadly in line with that of personable disposable income - although higher terms of trade and wealth are likely to support a slightly stronger profile" than previously expected.

As for net exports, now a key driver of economic activity, the central bank raised a red flag, saying the recent improvement "is expected to be further restrained by ongoing competitiveness challenges, which have been reinforced by the recent strength of the Canadian dollar."

The continued strength in the loonie, which has traded above $1.04 U.S. for the better part of a week, "could create even greater headwinds for the Canadian economy, putting additional downward pressure on inflation through weaker-than-expected net exports and larger declines in import prices."

The Canadian dollar has gained against its U.S. peer on stronger commodity and stock prices, as well as a sell-off of the U.S. currency over concerns about Washington's willingness to tackle its fiscal morass.

Entering Tuesday's decision, fixed-income strategists said they would focus on what the central bank had to say about the amount of spare capacity in the economy, otherwise referred to as the output gap.

Given the improved economic outlook, the central bank said it expects economic slack to be fully absorbed by the middle of 2012, or two quarters earlier than anticipated. And in this statement, the bank described spare capacity as "material excess supply," as opposed to "significant excess supply" as it did previously.

Economists suggest the central bank generally would like to get its policy rate to a so-called neutral level by the time economic slack dissipates.

Shrinking spare capacity also triggers inflationary pressure, and the central bank - which is mandated to set its rate to achieve and maintain two per cent inflation — said the run-up in food and energy prices were "contributing to the emergence of broader global inflationary pressures."

Canada's overall inflation is set to rise to three per cent in the coming months on higher energy prices and then drift toward the two per cent target by mid-2012. And while core inflation, which strips out volatile items such as food and gas, hit a record low in March of 0.9 per cent, the central bank said it would gradually rise to two per cent by mid-2012 as slack is absorbed, wage growth stays modest and productivity "recovers."