The Bank of Canada today announced that it is maintaining its target for the overnight rate at 4.25%. Today’s decision was widely expected by market watchers.

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

In announcing its decision, the Bank of Canada noted that economic activity in the second quarter of 2006 was somewhat below its expectations.

Inflation in July came in slightly higher than it had expected, however, due mainly to rising prices in the housing and services sectors.

The bank kept its cards fairly close to its vest about the future direction of interest rates.

“Looking forward, the bank continues to expect the Canadian economy to operate at about its production potential, with total consumer price index inflation returning to the two per cent inflation target in the second half of 2007,” the bank said in a commentary.

The bank said it judged that the current overnight rate is enough to get inflation back to its target.

The risks to that forecast, the bank added, include upward inflation pressure that could be added by Canadian household spending and housing prices. The “downside” risk to the bank’s outlook includes the possibility that a rapid slowdown in U.S. consumer demand could hurt Canadian exports.

The Bank of Canada’s next scheduled date for announcing the overnight rate target is October 17.

As today’s decision by the Bank of Canada to stand pat on rates was widely expected, the question for economists is when the next move will come, and in which direction. Most expect it to stay on the sidelines for the rest of the year, with possible rate cuts next year.

Bank of Montreal says that the central bank continues to believe that current interest rates are “consistent with achieving the inflation target over the medium term.” It notes that the Bank also sees the risks to the outlook as “roughly balanced,” with underlying strength in consumer spending tempering the possibility of a more pronounced slowdown in the US economy. “These comments point to steady rates at the next fixed announcement date on October 17,” it predicts.

“The Bank’s comments support our view that, with growth expected to remain moderate in the year ahead and core inflation to stay on target, the overnight rate will remain steady in the foreseeable future,” BMO adds.

BMO Nesbitt Burns says that the press release accompanying today’s decision was broadly similar to the July statement, with the Bank noting that growth was weaker than expected in the second quarter, “although the overall tone is a bit less dovish than expected”.

It singles out four tidbits that indicate the Bank still has some lingering concerns about inflation, “the statement notes the risks of rising domestic home prices, a new worry for the Bank; it doesn’t mention the Canadian dollar at all, suggesting comfort with the current level; it specifically notes that July CPI was a bit above the Bank’s expectations; and, it no longer mentions that medium-term risks are tilted to the downside, which had been a favourite theme from the Bank over the past year.”

“This statement shows just slightly more underlying concern about inflation than expected, while the Bank is no longer harping on the medium-term downside risks, and does not mention the Canadian dollar. This should quash any talk of a rate cut by the Bank (which we never regarded as a serious prospect in 2006),” BMO Nesbitt concludes. “We continue to believe that the Bank will keep rates unchanged at the remaining two meetings in 2006, as US growth slows and inflation pressures ease.”

TD Bank economists say that this morning’s decision reinforces its view that the peak in the overnight lending rate has been reached and that the Bank will remain on hold for the remainder of 2006.

“We believe that the risks to the Canadian economy are tilted more to the downside as slowing growth south of the border reduces demand for Canadian products, weighing heavily on Canada’s export performance. However, the domestic economy in Canada is expected to remain reasonably healthy, likely leading to nothing worse than several quarters of below trend economic growth,” TD says. “Meanwhile, inflationary pressures will likely dissipate as the economy accumulates a modest degree of slack and as energy prices moderate in response to a more benign outlook for hurricanes in the Gulf of Mexico, the end of the summer driving season in the U.S., and some modest improvements in the geopolitical landscape.”

@page_break@“So while the course of monetary policy is steady-as-she-goes for the remainder of this year, our view is that the next move the Bank will make is to cut rates in early 2007 to prevent the headwinds from the US from unduly stalling Canada’s economic momentum,” TD predicts. “Nevertheless, with economic growth expected to remain at or above 2%, the reduction in rates will likely be modest, on the order of 50 basis points over the first half of 2007.”

National Bank Financial says that it remains skeptical “that a further acceleration of final domestic demand (still viewed as an upside risk by the Bank) will be able to offset the downside risks coming from a US economic slowdown.”

In our opinion, the Bank’s assessment that both these risks are balanced is too optimistic. We think that unless we get very strong employment reports between now and then the Bank will be force to downgrade its growth assessment for the Canadian economy by the October 19 Monetary Policy Report. Such a development will open the door for possible rate cuts in the first half of 2007,” it concludes.