Interest rates are headed higher, say economists after reading of the Bank of Canada’s April 2002 Monetary Policy Report.

Bank of Montreal economists note that the central bank has revised up its outlook for Canada’s economy. It expects real GDP to grow at an annual rate of 4.5% in the first quarter of 2002, 3.5% in the second quarter and 3%-4% in the second half of the year.

The Bank of Canada forecasts annual growth of 2.25%-3.25% in 2002 and 3%-4% in 2003. (This compares with the Bank of Montreal’s more optimistic forecast of 3.2% in 2002 and 4.5% in 2003.)

“The report’s warning that interest rates need to rise in a ‘timely and measured manner’ is consistent with our outlook for the overnight target rate to rise in increments of 25 basis points at the five remaining policy announcement dates this year,” says BMO. It expects the overnight rate to increase from the current 2.25% to 3.50% by year’s end, before climbing to a more “neutral” 5.00% by the middle of next year. “However, because our growth forecast is more optimistic than the Bank’s, there is a risk that rates could rise more quickly than we anticipate.”

RBC Financial Group economists say that the report provided a very clear view that the Bank is growing increasingly concerned about future inflation risks and is preparing the markets for further rate hikes while noting that several important risks still remain.

“The Bank of Canada’s message rings loud and clear – interest rates are headed higher, and substantially so,” according to TD Bank. “It left little doubt that it no longer views the huge amount of monetary stimulus that has been put into place as being warranted… this overwhelmingly confirms our view that rates are set to rise by another 125 basis points this year, and 125 basis points in 2003 – which would bring the overnight rate to 4.75% before all is said and done.”

“Importantly, Governor Dodge noted in today’s Q&A session that Canada has a smaller spare capacity gap to make up than the United States. This line of reasoning suggests the Bank would be entirely comfortable raising rates further, even if the Fed stays on hold for the time being,” says BMO Nesbitt Burns. Dodge downplayed concerns over household debt in the Q&A, BMO notes. “Even if one disagrees with their assessment, the Bank is clearly in a hawkish frame of mind.”

“The Bank sounds like it will need to be convinced not to continue tightening steadily this year. A further increase of 100-125 bps of tightening looks likely through the remainder of 2002. The next policy date is June 4 — expect another 25 bp move, with or without the Fed,” concludes BMO Nesbitt.