Canada’s economy operated at full capacity in the first quarter, but a bit of slack opened in the second quarter, says the Bank of Canada in its July Monetary Policy Report Update. And it continues to signal that rate increases are likely sooner than later.

The bank says it expects Canada’s economy to grow by about 2.7% in 2005 and 3.3% in 2006. Bank governor David Dodge says that global and Canadian economic developments have been unfolding as expected, and the bank’s outlook for output and inflation in Canada through to the end of 2006 is little changed from the scenario outlined in the April Report.

“Strong growth in final domestic demand in Canada continues to offset the drag from net exports. Further progress has been made across sectors of the Canadian economy in adjusting to global developments, and the economy is operating close to its production capacity,” he says.

In the report, the bank notes that its conventional measure of potential output was revised down slightly from the estimate used in the April Report. As a result, the economy was operating at its capacity limits in the first quarter of 2005, instead of very slightly below its production capacity as projected in the last report. However, it suggests that a small amount of slack emerged in the second quarter.

The bank says it expects that the economy will continue to operate near capacity, and with inflation expectations firmly anchored, inflation is expected to return to 2% by the end of 2006. “In line with the bank’s outlook for growth and inflation, some reduction in the amount of monetary stimulus will be required in the near term to keep aggregate demand and supply in balance and inflation on target,” Dodge says.

Ahead of the report, one of the issues economists had been focused on was the bank’s view on productivity. The bank says that labour productivity was up 1% in the first quarter, below its assumed trend of 1.75% growth. Dodge says he expects capital spending to lead to increased productivity, but that even though this is the assumption, business and government and the bank must focus on improving productivity if the economy is to maintain its 3% growth capacity. Indeed, he adds that improved productivity is, “absolutely essential if we are to have rising real incomes into the future”.

The risks to the outlook through 2006 relate primarily to the future path of prices for oil and non-energy commodities, the pace of growth in China, and the ongoing adjustment of the Canadian economy to global developments. These risks appear to be balanced, the bank notes. “Over the medium term, however, there is increasing risk that the correction of global current account imbalances could involve a period of weakness in world aggregate demand,” Dodge says.