INTEREST RATES: Bank of Canada raises key overnight interest rate 0.75%

The Bank of Canada raised its benchmark policy rate Tuesday to 0.75% even though it scaled back its growth outlook on the belief budget cutting among households and governments in advanced economies is expected to “temper” the pace of the global recovery.

GDP in Canada is now expected to expand 3.5% this year and 2.9% in 2011, the central bank said, compared to its previous outlook in April of 3.7% and 3.1% growth, respectively. However, business investment and trade are expected to make a larger contribution to Canadian growth, which up until now has relied heavily on a confident consumer.

Plus, the bank pushed back the date at which it expects the Canadian economy to reach its full potential -- to the end of next year from mid-2011. Still, it opted for a rate hike as the “underlying dynamics” for inflation are little changed, with both headline and core inflation expected to remain near the bank’s preferred 2% target up until the end of 2012.

The central bank’s benchmark rate now stands at 0.75%, an increase of 25 basis points, and marks the second straight rate hike. The Bank of Canada remains the only central bank among its Group of Seven peers to raise rates following the recession.

And as it did in its June 1 statement, the central bank said further rate hikes “would have to be weighed carefully against domestic and global economic developments.” While further hikes are projected as the Bank of Canada moves away from emergency-level rates, there is debate as to how aggressively the central bank will move due to uncertain conditions in the global economy, especially among industrialized countries.

Prior to Tuesday’s decision, markets had priced in a roughly 80% chance of a 25-basis-point increase, although there was some doubt based on widespread weakness in most major U.S. economic indicators.

In its rate statement, the central bank’s only specific reference to the United States suggested private demand “is picking up but remains uneven.”

The central bank’s governing council reiterated that the global economy “is proceeding.” It said, however, the recovery is “not yet self-sustaining,” adding a “greater emphasis on balance sheet repair by households, banks and governments in a number of advanced economies is expected to temper the pace of global growth.”

As for Canada, the housing market -- which helped drive growth in the early stages of the recovery -- is “declining significantly” from high levels, the bank statement said. Strong employment growth, as demonstrated by the 93,000 new jobs created in June, has been offset

by timid business investment “held back by global uncertainties.”

As a result, the central bank slightly revised its near-term outlook downward for the Canadian economy, now calling for GDP to expand 3.5% in 2010 and 2.9% in 2011. Growth, however, is expected to be slightly stronger than anticipated in 2012, with expansion running at 2.2% versus 1.9%.

The revisions, the banks said, reflect a “slightly weaker profile for global economic growth and more modest consumption growth in Canada.”

Further, the central bank expects business investment and net exports to make “a relatively larger contribution to growth” in the near-term.

More detail is likely to be provided when the Bank of Canada releases its updated economic forecast on Thursday.

Nevertheless, data from last week indicated business investment and trade are beginning to pick up speed. Machinery and equipment import volumes, which are closely correlated to business investment, surged 4.1% in May, and 47.2% annualized in the past four months to mark a six-year high, according to economists at BMO Capital Markets. While Canada’s trade deficit widened to $500-million in May, export volumes rose month-over-month by a robust 3.9% -- which was offset by a 4.2% month-over-month gain in imports.

Further, Canadian manufacturing shipments rose 0.4% month-over-month in May.

(prepared by Paul Viera/Financial Post July 19, 2010)