The Bank of Canada today announced it is keeping its key interest rate at 4.25%.

The bank says despite robust domestic demand and an inflation rate over 2%, weaker exports and lower-than-expected productivity growth helped slow economic growth in recent quarters.

It says near-term prospects for economic growth will be curbed by a weaker U.S. economy. The bank has also reduced its growth forecasts.

It had been looking for a 3.2% increase this year but now predicts economic growth of 2.8%.

It’s also lowering its expectation for next year to 2.5% from 2.9%.

The Bank of Canada held its key overnight rate target steady at 4.25% today, yet


Bay Street economists say the central bank’s comments have pushed out the timing of possible rate cuts.

Bank of Montreal says, “The Bank estimates that growth in the second half of 2006 averaged about 1.6%, decidedly weaker than it anticipated at the time of the October Monetary Policy Report. However, it believes the softness is largely transitory, reflecting weak U.S. demand for Canadian-produced building materials and automobiles, where an adjustment has already taken place.” Domestic demand has continued to contribute strongly to growth too.

“The economy is forecast to operate near its capacity limits in the next two years, with core inflation returning to the 2% target in the first half of 2007. Accordingly, the Bank remains comfortable with the current level of interest rates, and sees the risks to its outlook as ‘roughly balanced’,” BMO says.

National Bank Financial suggests that the Bank was somewhat more forceful than in its previous press release in reaffirming its neutral bias. “Despite David Dodge’s mid-December comments that the Canadian economy was weaker than expected, the Bank appears to have been comforted by the recent string of economic indicators to the point where it has re-introduced in its press release the reference that the economy is operating at or above its production capacity – allowing it to maintain its inflation outlook intact,” NBF observes. “We are somewhat surprised by this in light of the much weaker-than-expected GDP growth in recent months. Has our central bank again downgraded its estimate for potential growth? We might find out in the upcoming MPR.”

For now, NBF says, it appears that the Bank of Canada is sharing the consensus forecast that there will be no significant spillover from the severe correction in U.S. housing to the rest of the economy and that the current imbalance in that sector will have been largely resolved by the end of the year, putting the overall U.S. economy on a stronger growth path. “At this point, we still think that there is considerable downside risk to this scenario,” it says. “Unlike the Bank, we see lesser scope for a sustainable rebound in U.S. demand for Canadian automotive and building products in the coming months.”

NBF says, “ With the Bank having dug its heels in the sand, the overnight rate will be maintained at its current level for some time, and would only ease in reaction to a sequence of much weaker-than-expected data (labour in particular). Given our below consensus view, we still believe that rate cuts in Canada will be needed but the timing of such action will occur a little later than we had previously assumed. We see 50 basis points of easing in 2007 starting in the second quarter.”

RBC says that it expects the Bank to hold the policy rate steady until mid-year when a rate cut is likely. “The economy disappointed in the fourth quarter meaning that the economy will move from a state of excess demand to more balanced conditions sooner than the second half of 2007 which was projected in the Bank’s October forecast. Still with the core inflation holding above the mid-point of the Bank’s 1% to 3% target, it does not leave the Bank much room to lower the overnight rate at the present time,” it says. “High costs associated with housing, the low unemployment rate and relatively high capacity usage are consistent with the core inflation rate holding above 2%.”

“Today’s statement indicates mild alterations to the growth and inflation forecasts with the detailed projections to be released in Thursday’s Monetary Policy Report Update. On balance, we see little in today’s statement that changes our view that the Bank’s next move will be to lower the overnight rate to 4% this summer,” RBC adds.

@page_break@“Policymakers are clearly upbeat on the economy’s growth prospects and are in no hurry to reduce rates to address the recent soft patch,” BMO agrees. “This suggests rates will be held steady at the next fixed announcement date on March 6. A downward surprise in either growth or inflation is likely required to spur a rate reduction beyond then.”

“All together, the statement was neither hawkish nor dovish and stands as a testament to the data dependent wait-and-see approach to monetary policy,” TD Bank says.

“While a more thorough assessment of the economy will be contained in the update to the MPR set to be released on Thursday, today’s statement presents an optimistic outlook for economic growth on both sides of the border,” TD says. “While there are some tentative signs that the correction in the U.S. housing market has run its course, we feel that further weakness is likely. Furthermore, while strong personal income growth has buoyed U.S. consumer spending, there will likely be some moderation in spending as falling home prices cuts into the growth rate of household wealth. This link remains the key risk to the economic outlook and if the pace of consumer spending in the U.S. slows by more than expected, the Bank will be forced to acknowledge a greater downside risk to their economic outlook.”

The Bank of Canada will release its Monetary Policy Report Update, to be published on Thursday.

The bank’s next scheduled date for announcing the overnight rate target is March 6.