The Bank of Canada likely choose to hold interest rates steady next week, predict TD Bank economists, but they suggest the central bank’s policy statement may be more upbeat than what the markets are expecting.

“Despite the fact that the dust has largely settled following the market turmoil that began in mid-August, there are still some calling for rate cuts from the Bank of Canada in the months ahead. We believe any such expectations are bound to the disappointed and we remain of the view that the next move from the Bank of Canada is much more likely to be an increase in rates rather than a decrease in rates,” TD says.

In the meantime, it believes that the real issue in next week’s scheduled announcement is what the Bank of Canada will say in its statement on Tuesday, and in the Monetary Policy Report released on Thursday, where they get a chance to fully flesh out their views on the impact of the credit crunch and where the economy is headed. “And on that front we think that the markets, and particularly those calling for rate cuts from the Bank of Canada, may be surprised by a more upbeat tone from the Bank of Canada than they were expecting,” it says.

TD says that the Bank of Canada will not cut rates because inflation has been above the 2% target for a year now and it is likely to remain so; the labour market is extremely hot, and continues to defy expectations; capacity constraints do not appear to be waning; the economy continues to beat the Bank of Canada’s expectations; and, due to base year effects, there is a good chance that even modest rises in consumer prices in the near term will lead to higher core CPI inflation before year-end.

It allows that, despite the number of upside risks to the inflation outlook, the downside risks to the economic and inflation outlook certainly cannot be ignored. These risks include the recent appreciation of the Canadian dollar, and the possibility of a significant slowdown, or even an outright decline, in U.S. economic growth.

As for the credit market disruption, TD says that while some aspects of the short-term market have still not fully returned to normal, conditions are much more stable now than they were at the time of the last rate setting and they appear to be getting better all the time. “By our estimates, the market turmoil was equivalent to less than half of a 25 basis point hike from the Bank of Canada, and therefore should have a minimal impact,” it says.

“The implication of all of the above is that the Canadian economy is likely to experience modest economic growth in the coming quarters. Domestic demand is expected to be strong, and there are upside risks on this front. However, exports will be a major headwind for the economy, reflecting weak U.S. demand and the fallout of a strong currency,” it adds. “Thus, the pace of economic growth is expected to slow to an average pace of 2.3% next year, but that is only modestly below its long-term potential pace of 2.8%, which implies inflation will be slow to return to the 2% target.”

As a result, TD expects that next week’s statement will be more upbeat in tone than the last. “Now that the dust has settled and we’ve had a chance to observe the fall-out of the summer’s market turmoil, the amount of uncertainly surrounding the economic outlook has diminished, and with it some of the downside risk,” it says. It expects the Bank of Canada will signal to the markets not to expect rate cuts.

“The Bank is unlikely to signal a future tightening, but this is where we feel the risks squarely lie. A major monetary policy tightening cycle is not in the cards, due weakness in the U.S. and the dampening impact on economic growth from a currency above parity. Nevertheless, if inflation continues to run above the 2% target in the coming months, and we expect it will, the Bank will eventually feel the need to send a strong message to financial markets that it is not getting soft on inflation and inflation expectations should remain rooted at the 2% mark,” TD concludes. “This is why we see the Bank delivering one quarter point hike to reaffirm its inflation fighting credits, and it could come as early as December.”