As widely expected, the Bank of Canada today held its key overnight interest steady.

The bank’s key overnight interest rate has been 4.5% since July, when it was boosted by a quarter of a percentage point.

The operating band for the overnight rate is unchanged, and the bank rate remains at 4.75%.

Despite these recent tighter credit conditions, momentum in domestic demand in Canada is expected to remain strong, the bank stated.

In the wake of the announcement, the Canadian dollar was trading at US102.49¢, up 0.07 of a cent.

The recent appreciation of the Canadian dollar against the U.S. dollar, coupled with an outlook for lower U.S. economic growth, mean the domestic economy will slow down next year, the bank said.

After posting growth of 2.6% this year, growth is expected to cool to 2.3% in 2008 and then pick up to 2.5% in 2009, the bank forecast.

The forecast for growth in the United States has been revised downward, the bank said, to 1.9% in 2007 and 2.1% next year because of a greater-than-expected slowing in the housing sector.

The bank also said it sees the overall and core inflation rates returning to its stated target of 2% in the second half of 2008.

The core rate — which factors out some volatile elements — stood at 2.2% in August, while overall inflation fell that month to 1.7% after having been above the 2% target since the spring.

The Bank of Canada said it judges the risks to its inflation outlook to be slightly tilted to the downside.

The bank cautioned Canadian consumer demand could persist longer than expected, but also noted that the rise in the Canadian dollar could take some steam out of domestic economic growth and inflation.

Bay Street economists remain divided and uncertain over where Canadian interest rates are headed.

RBC Capital Markets reports that the Bank said that “against a backdrop of robust global economic expansion and strong commodity prices”, Canada’s “economy is now operating further above its production potential than had been previously expected.” Once again, the Bank highlighted that Canada’s domestic economy is expected to remain strong, RBC noted.

“However moderating the outlook for Canadian growth was the tightening in Canadian credit conditions following financial market developments this summer, and the combination of a weaker growth profile for the U.S. economy and stronger Canadian dollar which are expected to temper demand for Canadian exports,” it added.

The central bank now assumes that the loonie will remain in US98¢ range, up from July’s US93¢ to US95.5¢ assumption. However, it warns that if the currency remains above this new assumption, “for reasons not associated with stronger-than-projected demand for Canadian products, Canadian output and inflation would be lower.”

RBC says that it remains comfortable with its view that the Bank of Canada will hold the policy rate at 4.5% until late next year. Its forecast calls for domestic demand to remain firm with the expected drag coming from the trade sector (on the back of weaker export volumes) resulting in economy slowing modestly but not sufficiently to shift out of the state of excess demand meaning that residual inflation risks will remain. “This suggests that the next move by the Bank is likely to be a hike but that it could be a long time in coming and we have penciled in a move to 4.75% in the fourth quarter of next year.”

National Bank Financial takes the opposite position, predicting that some modest easing in monetary policy will be required over the next six months in Canada. “Obviously, political developments in Ottawa will have to be taken into consideration. The extent of monetary easing required will need to be gauged against potential fiscal stimulus from the Federal government. At this writing, our baseline forecast for the overnight target rate is still 4.0% by the end of March 2008.”

BMO Nesbitt Burns concurs with that view, saying, “The Bank has little intention to adjust rates anytime soon, provided that the economy remains on track. However, if growth remains weak in coming quarters, as we anticipate, a rate cut is probably in the cards before the spring of 2008.”

TD Bank believes that policy remains on hold for the foreseeable future. “The main conclusion is that the Bank was worried this past summer about the upside risks to inflation. This is why they hiked rates 25 basis points in July and telegraphed the likelihood of more to come. Then, the credit crunch hit in August and the Canadian dollar soared. These developments will act as a restraining force on the economy, and the Bank deems that they will be sufficient to keep inflation in check,” it says.

“This is not a signal that an easing in monetary policy is in the cards, unless the downside risks start to play out,” TD concludes. “However, it is a signal that the Bank does not believe that they have to worry about inflation running above target in the near term and suggests that rates are on hold for the time being.”

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A full update of the central bank’s outlook for growth and inflation will be set out in the Monetary Policy Report, to be published on Thursday, October 18.

The bank’s next scheduled date for announcing the overnight rate target is December 4.