The Bank of Canada today announced that it is maintaining its target for the overnight rate at 4.25%.

The operating band for the overnight rate is unchanged, and the Bank Rate remains at 4.5%.

The rate has not moved since May 24, 2006, when the bank raised it by one-quarter of a percentage point.

In the commentary accompanying the rate decision, the bank said food and gasoline prices have recently risen more than expected.

The bank said core inflation, which factors out volatile components including some energy and foods costs, is projected to decline to 2% by the end of 2007.

Overall inflation is projected to rise above the 2% inflation target in the second half of this year, before returning to the target by mid-2008.

Despite the central bank’s stressing of its inflation concerns, Bay Street economists see rates remaining on hold for the rest of the year.

National Bank Financial says that the Bank of Canada remains comfortable with the current level of interest rates “mostly because of the greater uncertainty surrounding the U.S. economic outlook (which has resulted in a slight downward revision to its forecast to the contribution of trade to Canadian economic growth this year).”

“Under these circumstances, it appears that our central bank is willing to remain patient by keeping its neutral stance despite the still vibrant domestic economy,” NBF noted. “This being said, the Bank is now recognizing that the risk for its inflation forecast is now slightly tilted to the upside. This is a significant change from previous statements as it opens the door for a possible change of bias should the economy pick up steam in the second half of 2007 or if wage inflation begins to accelerate at the national level.”

TD Bank says that by acknowledging that the current rate of inflation has been higher than previously expected, the Bank now characterizes the Canadian economy as operating just above its productive capacity. “This is entirely consistent with both the recent performance of the labour market, which has pulled the unemployment rate down to a generational low, and the Bank’s own Business Outlook Survey, which noted that an increasing share of firms would have difficultly responding to an unanticipated increase in demand,” TD said, adding that, “Despite these challenges, the Bank expects that core inflation will cool towards the 2% target, but have pushed the timing from the second quarter to the end of the year.”

On the prospects for economic growth, the Bank left its projection for real GDP growth essentially unchanged, TD said, as real GDP growth is expected to increase by 2.2% in 2007 and 2.7% in 2008.

“The most pressing issue in understanding the future direction of interest rates remains an economy verging on excess demand. Still, consistent with the Bank’s base case, our bet is that the U.S. economy continues to struggle over the next few quarters, holding growth in Canada to below its potential rate and leading to a gradual easing in the core inflation rate. As such, the greatest likelihood remains no change in the overnight target rate through the end of 2007, although in light of the Bank’s concerns about inflation, one certainly cannot dismiss the possibility of a rate increase,” TD concludes.

“Today’s statement finds a middle ground between an outright hawkish message and a neutral status quo,” observes BMO Capital Markets. “While somewhat more concerned about inflation pressures at this stage, the Bank remains wary about the downside risk from U.S. growth, reinforcing the point that they are in no rush to go anywhere.”

“Unless core inflation or growth sprints higher, the Bank is likely to bide its time until the U.S. economy stabilizes and begins picking up again — a process that may take until late this year, or even into early 2008 judging by today’s soft housing and confidence data,” BMO predicts. “We continue to believe the next move will be a modest rate hike in early 2008, and there’s nothing here to deflect that view.”

“With the prolonged weakness of the U.S. economy providing some offset to domestic strength, we believe
that the Bank of Canada was justified to retain its neutral policy stance at this time. Having said this, this neutral bias is beginning to look more and more like the leaning tower of Pisa. How long will it continue to defy gravity?” NBF asks. “Developments in Canadian and U.S. labour markets will be important to watch in this regard.”

@page_break@“Given our own view for the U.S. economy and its impact on our exporters, we believe that the odds remain in favour of the Bank of Canada standing pat through the rest of the year,” NBF concludes.

The central bank’s next scheduled date for announcing the overnight rate target is May 29.