Canada’s economy is operating below capacity says Bank of Canada Governor David Dodge, and the central bank will use monetary policy to push it toward capacity even though interest rates will have to head higher eventually.

Dodge made his remarks today in his opening statement to t House of Commons Finance Committee. He reiterated much of what was said in the central bank’s April Monetary Policy Report, released last week.

In that report, the Bank of Canada said that the global economy “has been unfolding largely as expected”, and “the Canadian economy continues to adjust to global economic developments”.

The global developments include huge trade and fiscal imbalances, higher commodity prices and increasing emerging economy competition. As a result, Dodge noted, “Many Canadian commodity-producing sectors are expanding. However, firms in some other sectors that are exposed to international trade are facing pressure from the appreciation of the Canadian dollar and from foreign competition.”

“On balance, net exports have been a drag on the economy. But with robust domestic demand, some sectors — such as retail, wholesale, and housing — have been growing strongly,” he said.

The Bank of Canada expects Canada’s economy to grow by about 2.5% in 2005 and 3.25% in 2006, with growth this year and next coming primarily from strength in domestic demand.

“The Bank continues to judge that the economy is operating slightly below its production capacity, and we expect that it will move back to full capacity in the second half of 2006,” Dodge said.

“Core inflation is projected to return to 2% around the end of 2006. Based on the scenario implied by oil-price futures, total CPI inflation is expected to remain slightly above 2% this year, and to move slightly below 2% in the second half of 2006. In line with this outlook for growth and inflation, a reduction of monetary stimulus will be required over time.”

This outlook is subject to both upside and downside risks and to uncertainties, he added. “The risks include the pace of expansion in Asia and the prices of oil and non-energy commodities. A further risk relates to the resolution of global current account imbalances. Should these imbalances persist, the risk of a disorderly correction would grow over time. Most of the uncertainties with respect to the Canadian outlook relate to how the economy is adjusting to the relative price changes associated with major global developments,” Dodge said.

“Monetary policy continues to facilitate the adjustment process by aiming to keep inflation at the 2% target and the economy operating near its production capacity,” he concluded.