The Bank of Canada has trimmed its outlook for short-term economic growth.

The central bank said in the January update to the Monetary Policy Report that real GDP growth is a bit lower than previously expected. The report was released today.

Growth is now expected to average about 2.5% in the first half of 2007, rising to about 2.75% in the second half of this year.

In 2008, growth is projected to remain in line with the growth of potential output (estimated at 2.8%), keeping the economy operating near its capacity throughout the projection period. Expressed on an average annual basis, this profile implies growth of 2.3% in 2007 and 2.8% in 2008.

The forecast for 2007 is down from 2.5% in the October MPR.

The Bank said that the Canadian economy is judged to have been operating at, or just above, its production capacity at the end of 2006, following weaker-than-expected growth in the second half of last year. This slowdown stemmed from reduced demand for Canadian exports — related to weakness in the U.S. automotive and housing sectors — and from the need for Canadian businesses to adjust inventories.

Total consumer price inflation will continue to be affected by movements in energy prices and, during the first half of 2007, by last year’s reduction in the GST. Total inflation should average just above 1% in the first half of this year, returning to the 2% target in early 2008. Core inflation should return to 2% in the first half of 2007 and stay there.

On January 16, the Bank left its key policy rate unchanged at 4.25%. The Bank says that the risks around its inflation projection continue to be judged to be roughly balanced, but the main upside and downside risks have diminished somewhat since the October MPR. “The current level of the policy interest rate is judged, at this time, to be consistent with achieving the inflation target over the medium term,” it says.

Reacting to today’s update, economists say that the Bank of Canada may keep rates on hold this year.

BMO Nesbitt Burns says that there is not a whole lot of new information in this report, “It does, however, remove uncertainty about whether the Bank’s tone would shift. It didn’t. The Bank remains upbeat on Canada’s growth prospects.”

TD Bank agrees, noting, “If Tuesday’s extremely neutral communiqué was a splash of cold water on the prospect of imminent interest rate cuts, this morning’s release of the update to October’s Monetary Policy Report dumped the rest of the bucket. Despite acknowledging weaker economic growth over the second half of 2006, the Bank of Canada feels that the current level of interest rates is consistent with keeping inflation on target and that the Canadian economy continues to operate at, or just above, its productive capacity.”

“The Bank believes the economy’s troubles last year are largely due to special factors (U.S. housing correction, automotive industry restructuring, and Canadian inventory correction) that have already shown signs of abating,” BMO Nesbitt says. “Thus, growth is expected to pick up appreciably from the crawling 1.6% pace estimated for the second half of 2006 to 2.5% in the first half of this year, and then to a potential rate of 2.8% in the second half of 2007.”

This stance is causing BMO Nesbitt to shift its rate forecast. Previously, it predicted a 25 basis point cut was likely by mid-year. “But with subsequent economic data becoming much more upbeat, and in light of the recent depreciation in the Canadian dollar and the Bank of Canada’s judgment of lower downside risks — not to mention that core inflation lingers stubbornly above 2% despite the Bank’s optimism — we now believe that the Bank will remain on hold through 2007.”

“The Bank doesn’t believe the economy is sick enough to require a spoonful of monetary medicine. Unless it is wrong about growth, rates are now unlikely to decline this year,” it says. “In fact, if the patient recovers too quickly, the next move could be up, not down.”

However, TD says that the report presents what may be the best-case view of Canada’s economy. “We feel, however, that there is a risk that economic growth may ease by more than the Bank’s forecast in the early part of 2007. This will allow some economic slack to build and open the door to the potential for a very modest 50 basis points of monetary stimulus,” it suggests. “It is important to recognize that this move would be tantamount to an insurance policy against a more protracted slowing in the Canadian economy. However, if we take the Bank at their word, the odds of such a development at this point are significantly reduced.”