Even as it held off hiking rates today, the Bank of Canada left little doubt that rates are going higher in September, economists say. They predict a 25 basis point hike will come in early September.

Bank of Montreal economists note an important change in tone to the Bank’s press statement. It “states bluntly that ‘some reduction in the amount of monetary stimulus will be required in the near term. Previously, the Bank was saying that the reduction could take place ‘over time’.”

“The statement expressed little concern about the economic impact of the high Canadian dollar, one factor keeping the Bank on the sidelines in the last nine months,” BMO adds. “Most importantly, the statement said that the economy is now ‘operating close to its production capacity’.”

“The Bank has held the key policy rate unchanged since October 2004 in order to facilitate the adjustment of the Canadian economy to global developments. The strategy has worked well so far. The economy is now operating close to its production capacity, so the time to readjust the policy stance is coming,” says National Bank Financial.

And, it sees the same hints as BMO in today’s statement. “The Bank explicitly recognizes it in today’s press release, by changing the wording about its assessment of when monetary policy adjustment will be needed from the vague and distant ‘over time’ formula to today’s less open ended sentence.”

It suggests that the Bank is “widely opening the door for a rate hike on September 7”. Thursday’s Monetary Policy Report Update is expected to include more clues as to the Bank’s next move.

TD Bank says that although the Bank’s promise of a reduction of ‘some’ monetary stimulus might sound like a more dovish twist than before, its influence is more than offset by the extremely hawkish ‘in the near term’. “In short, the Bank of Canada appears to be signaling its intention to raise interest rates by 25 basis points in September,” it says. “Markets clearly agree with this interpretation, with the Canadian dollar rocketing up three-quarters of a cent to almost 83¢ in morning trading, and with Canadian bond yields also surging.”

“We have been forecasting a series of interest rate hikes in Canada before the end of the year for some time, and suspect that the anticipated September move will only mark the first of many increases, culminating in a 4.00% overnight rate toward the middle of 2006,” TD adds.

BMO notes that while rates are poised to head higher, the pace of tightening will likely be kept gradual. “This is because the Bank expects economic growth to trend around its potential pace (of about 3%) in the year ahead, so excess demand pressures should not emerge. As a result, the Bank still expects inflation to return to the 2% target by the end of 2006.” It predicts that, barring stronger-than-expected economic data, the September hike should be limited to 25 basis points. “Beyond September, we see overnight rates rising steadily to a more neutral level of 4.5% by early 2007.”

That said, TD cautions that it is clear that many things can happen between now and September. “The Bank of Canada itself says ‘global imbalances are increasing’. In the past, they have identified the U.S. current account deficit as a key concern. We would also highlight high-energy prices and record U.S. household indebtedness as further problems that could easily spill across the border, causing trouble in Canada. As such, global risks will need careful monitoring, but none are likely to deter higher interest rates in the near term.”