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Bank of Canada hikes key interest rate

The Bank of Canada raised its benchmark interest rate Wednesday by 25 basis points to 1%, arguing financial conditions remain “exceptionally stimulative” even in the face of a slowing — but still growing — economy.

Following the announcement, market watchers said traders reduced the odds of another rate hike for the remainder of 2010 as they focused on the final line in the statement which said any further reduction in monetary policy stimulus would need to be carefully considered in light of the “unusual uncertainty” over the economic outlook.

“This is key … as it appears to indicate the Bank of Canada’s intention to pause the [rate-hiking] process,” said Michael Woolfolk, senior currency strategist at BNY Mellon in New York, adding the pause could extend beyond the “next meeting or two.”

Not all analysts shared that view, with some saying the central bank could hike its benchmark rate yet again this year.

In the statement, the central bank acknowledged the economic recovery in Canada would be “slightly more gradual” than envisaged it its most-recent economic outlook, due to sluggish private-sector demand in the United States. However, it said domestic demand was expected to be “solid” and business investment to advance “strongly” — powered by “accommodative” credit conditions that have eased further in recent weeks due to sharp declines in bond yields.

Banks price loans, such as mortgages, based on yields for relatively safe government-issued debt.

“As a result of monetary policy measures taken since April, financial conditions in Canada have tightened modestly but remain exceptionally stimulative,” the central bank said.

Consumers continue to take out loans at a steady pace, with central bank data suggesting household credit expanded at an annualized 7.1% pace for the three-month period ended July 31.

Yet, the Bank of Canada said future hikes in its key lending rate, up 75 basis points in the past three months, “would need to be carefully considered in light of the unusual uncertainty surrounding the outlook.”

Jonathan Basile, economist at Credit Suisse, said reference to “unusual uncertainty” — which roughly mimics wording from U.S. Federal Reserve chairman Ben Bernanke — could be interpreted as a sign that conditions have deteriorated. As a result, Mr. Basile said he expects the central bank would refrain from further rate hikes until the second half of next year.

Conversely, Douglas Porter, deputy chief economist at BMO Capital Markets, said the statement was “more hawkish” than anticipated and suggests the central bank retains a bias toward further rate increases.

“While we had been expecting the bank to now move to the sidelines for a spell, it appears that it will take a deeper slowdown in domestic spending and core inflation than what we have seen so far to prompt them to stop raising rates,” he said.

Yields on government of Canada bonds rose slightly across the curve, and the Canadian dollar shot up roughly US0.50¢ following the central bank decision. As of 11 AM ET, the loonie was up nearly US1¢, to the US96.40¢ range.

Up until Wednesday, traders were largely divided as to which way Mark Carney, the central bank governor, and his colleagues would lean toward in the face of slower than anticipated economic growth. Markets had priced in a roughly 60% chance of a rate hike, and those odds increased from a less than 50-50 chance based on better-than-expected manufacturing and labour data in the United States.

Canadian GDP expanded 2% annualized in the second quarter, well below the central bank’s forecast of 3%. However, analysts have said the economy was stronger than the headline print indicated, as final domestic demand advanced at a robust pace (3.5%). Plus, much of the drag in the second-quarter was from so-called “import leakage,” in which gains in imports — as firms acquired productivity-enhancing equipment at the fastest pace since 2005 — outstripped exports.

Of the GDP results, the Bank of Canada said economic activity “was slightly softer” than expected, “although consumption and investment have evolved largely as anticipated.” The bank said the Canadian recovery would be “slightly more gradual than it had projected in July … largely reflecting a weak profile for U.S. activity.”

Meanwhile, inflation — which the central bank aims through rate decisions to hit and maintain a 2% level — has been “broadly in line” with expectations and “its dynamics are essentially unchanged.”

Mark Chandler, head of fixed-income and currency strategy at RBC Capital Markets, said the Bank of Canada statement indicates the central bank is putting more weight on overall financial conditions than perhaps traders had anticipated, citing the reference to the “sharp drop” in bond yields.

“The bank is saying financial conditions have gotten quite easy, because of the [bond] markets pricing in a gloom-and-doom scenario,” he said. “So by tightening now, it is not such an aggressive move — that’s the bank’s justification.”

In terms of the global economic picture, the Bank of Canada said the recovery is proceeding “but remains uneven, balancing strong activity in emerging market economies with weak growth in some advanced countries.” As for the United States, the world’s biggest economy and Canada’s biggest trading partner, the central bank said the recovery in private demand is “being held back by high unemployment and recent indicators suggest a more muted recovery in the near term.”

Economists have scaled back growth expectations for both Canada and the United States, although at the same time boosting the forecast for Europe as its major economies are advancing better than expected following the sovereign debt crisis in the spring.

The central bank is scheduled to provide an updated economic outlook next month, two days following its next rate decision on Oct. 19. Previously, the central bank had forecast 3.5% economic growth this year, followed by 2.9% expansion in 2011. The output gap — a rough measure of the amount of excess capacity in the economy — is expected to close by the end of 2011.

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