Speaking to the Italian Bankers Association Tuesday, Bank of Canada governor David Dodge said Canada’s central bank is prepared to raise interest rates to fight inflation.

In his speech Dodge said inflation in Canada has been above its 2% target for the past few months, while monetary policy remains stimulative with low interest rates.

Dodge repeated that the Bank continues to expect expansion somewhat below the 3% growth rate of the economy’s production potential in the first half of the year. Growth should accelerate in the second half as global uncertainties diminish. The Bank expects the level of economic output to remain close to capacity during 2003 and into 2004.

He also reiterated the Bank’s worries about inflation. Dodge noted that the Bank’s initial analysis was that increases in inflation would be temporary. “However, both core and total CPI inflation remain well above target. This reflects the impact of higher-than-expected prices for crude oil and natural gas, continuing increases in auto insurance premiums, and price pressures in certain sectors, such as housing, food, and some services. The higher inflation also suggests an underlying firmness in the price-setting environment. In other words, relative price increases wouldn’t be pushing up trend inflation if there was not sufficient demand.”

Dodge noted that final domestic demand has remained robust, but economic growth moderated in the final three months of 2002, largely because of weaker exports. “Even with this slowing growth in the fourth quarter, upward revisions for previous quarters leave the level of economic activity slightly higher than we had been monitoring. In fact, Canada’s economy remains near full capacity,” he said.

“While we continue to foresee growth somewhat below potential in the first half of this year, we expect increased demand in the second half of 2003 and into 2004, as global uncertainties diminish. But with an appropriate reduction in the amount of monetary stimulus, we see the level of output remaining close to capacity during this year and into 2004,” he said.

“Over time, further reductions in monetary stimulus will be required to return inflation to the target over the medium term. But, as we have said, the timing and pace of increases in policy interest rates will continue to depend on a number of considerations,” he concluded. “These include the strength of demand pressures; the evolution of inflation expectations; the impact on confidence of geopolitical and global economic uncertainties; and the way in which developments in the Middle East affect demand and inflation, both globally and in Canada.”