Bank of Canada says need to hike rates diminished

"In light of slowing global economic momentum and heightened financial uncertainty, the need to withdraw monetary policy stimulus has diminished," the central bank said in a statement.

In its July interest rate announcement, the bank said stimulus "will be withdrawn" provided the economy kept growing, leading markets to expect a rate hike later this year.

That forecast looks outdated now, given the European debt crisis, slowing US growth and volatile markets.

"There is really not much hint that the bank is considering cutting rates, but at the same time, they've pretty much put rate hikes firmly on the shelf," said Doug Porter, deputy chief economist at BMO Capital Markets.

Goldman Sachs this week became the first to forecast a Canadian rate cut later this year. The Bank of Canada's language left the door open to a move in either direction.

The change of heart brings the Bank of Canada into line with other major central banks ahead of a G7 meeting in France on Friday at which policy makers are expected to commit to keep monetary stimulus in place. Brazil unexpectedly cut rates on Aug. 31 and there are calls for the European Central Bank to halt its tightening cycle.

The US Federal Reserve, taking a leaf out of Canada's mid-recession playbook, has promised to leave interest rates low for a prolonged period.

For some, the Canadians were less dovish than expected.

"It still has these lingering elements of the hawkish," said Stewart Hall, currency strategist at RBC Capital Markets.

"Most, including ourselves, were looking for more of an overt move to neutrality that would have in a sense sidelined any talk of the need to withdraw monetary stimulus."

The Canadian dollar weakened briefly against the US dollar and swap markets pared back expectations for a near-term rate cut.

The yield on the two-year Canadian government bond, which is especially sensitive to Bank of Canada interest rate moves, rose to 0.915 percent from 0.883 percent just before the announcement.

GROWTH TO RESUME

The bank said several of the downside risks it identified in its July Monetary Policy Report had materialized, yet it sees Canadian growth resuming in the rest of 2011 after a second-quarter contraction. Exports will remain "a major source of weakness" because of soft demand from major trading partners and a strong currency.

Derek Holt, economist at Scotia Capital, said the bank appeared to be over-optimistic on growth, although he still expects the next move on rates to be up.

"I think we had a weak economy throughout the first half of the year and there are more considerable question marks about the outlook over the next six to nine months than the bank is letting on, but we'll see," he said.

The Bank of Canada said headline inflation will continue to moderate and core inflation will remain contained, and overall inflation expectations are well-anchored.

It cited discouraging US economic data, the European sovereign debt crisis and market volatility as the backdrop to its policy shift, nothing that US growth will be weaker than previously expected and fiscal and financial strains in Europe could prompt even more severe market dislocations.

Copyright Reuters, 2011