Economists are sticking with their call for a 25 basis point rate hike at the Bank of Canada’s September meeting, and a series of modest increases after that, following the bank’s Monetary Policy report released today.

This expectation was clearly established earlier this week when the Bank of Canada held rates steady but as TD Bank says, “set markets churning by all but announcing a September hike of the overnight rate”.

“Inevitably, today’s Monetary Policy Report Update seems anticlimactic by comparison,” it notes, but TD says there is insight to be had from the report. “All in all, the Bank of Canada remains cautiously optimistic about Canada’s economic outlook. Look for a rate hike in September, and further increases in interest rates extending extending into 2006. However, the pace of tightening will remain modest and the ultimate level will remain low by historical standards, with the overnight rate cresting at 4% in early 2006.”

“The key to expecting rate hikes soon is that the Bank is saying that [it has] revised downward [its] measure of potential output compared to the estimate in the April edition of this report,” says RBC Capital Markets. This change took place partly because of GDP revisions and partly because productivity growth remains below the Bank’s assumption for trend growth in productivity. “A view on how rapid productivity growth may be over the quarters ahead is critically important to evaluating potential output in the economy. A downward revision to potential output means that the economy comes up against potentially inflation-inducing capacity pressures earlier than previously expected,” RBC says.

However, RBC notes that “a considerable amount of data remains to be evaluated before the next rate announcement on Sept.7. The Bank left itself some wiggle room in noting that it thinks that [although] the economy was likely operating at its production limit in the first quarter (instead of its earlier opinion that the economy was operating very slightly below capacity), it then slipped back into slight excess supply conditions in the second quarter. They also noted that they expect second half growth to be about 3% which is roughly in line with their expectations for potential output growth. That possibly suggests no imminent movement back towards balance with potential output, let alone any fears of tripping into excess demand any time soon.”

BMO Nesbitt Burns comments, “There are no major shifts in direction here. Look for Canadian short-term rates to rise 25 bps in September and another 25 bps in October. However, an aggressive rate-hike cycle is not expected, which explains why the Bank continues to play up the medium-term risks to the outlook.”

National Bank Financial says that, “The Bank sounds ready to pull the trigger. But in pointing out that over the medium term there is a risk that correction of global imbalances could entail a period of weakness in world aggregate demand, the Bank is suggesting that it will use a sniper’s smaller-calibre rifle rather than heavy artillery. The Bank does not want to over-brake the economy.”

“In central bank language this sounds to us like a measured pace – a quarter-point in both September and October. However, the Bank could be caught off guard by international trade, which it assumes will remain a drag on the economy until sometime in 2006,” NBF says.

Bank of Montreal agrees that the report’s fairly sanguine outlook for inflation suggests a gradual pace of tightening. “The Update supports our view that the current overnight rate target of 2.50% will be raised by 25 basis points on September 7. Beyond that, we project similar-sized increments at roughly every second fixed announcement date until the target rate is at a more neutral level of 4.50% by early 2007.”