BANK OF CANADA RAISES RATES

OTTAWA- 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.

In its accompanying 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 debt.

The statement provided no suggestion the central bank was set to keep rates on hold for an indefinite period, as some analysts now expect.

“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.

For instance, 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.

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.”

This decision may come as a bit of a surprise for traders, who have been 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 over the past week 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 central bank is likely pleased at the turnaround in business investment, which it has argued is required for the recovery to maintain momentum once consumer spending tapers off. Plus, investment from firms in productivity-enhancing technology is required to ensure future growth.

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.” The U.S. Federal Reserve has said it was prepared to take further action if required to stoke the recovery, although officials at the powerful central bank are unsure such measures are required.

The Bank of Canada said 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.”

In terms of the global picture, it 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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