Against the expectations of many economists, the Bank of Canada has raised the overnight rate target by 25 basis points to 3.25%.

Most economists acknowledged that this decision would be a close call, but they thought the Bank would hold off from the rate hike because of global economic and geopolitical uncertainty.

However, the Bank noted that since the last interest rate announcement on March 4, both core and total CPI inflation have remained well above its 2% inflation target and measures of inflation expectations have edged up. “Economic growth in Canada in the second half of 2002 and in early 2003 eased from its earlier vigorous pace, but domestic demand has remained firm and employment gains have continued. As a result, the level of economic activity in Canada remains near full production capacity,” it said.

The Bank also allowed that the near-term outlook for the global and Canadian economies is somewhat weaker than was expected at the last rate announcement. “Nonetheless, with geopolitical uncertainties diminishing and world oil prices declining significantly, the risks confronting the global economy are now better balanced,” it said.

“The Bank thus expects that economic expansion in Canada and the United States will begin to strengthen towards the end of 2003 and will strengthen further in 2004. In view of the domestic inflation environment and the expectation that the Canadian economy will be operating near potential in 2004, the Bank has decided to further reduce the amount of monetary stimulus by raising the target for the overnight rate.”

The Bank of Canada’s decision prompted major banks to raise their prime rates by one-quarter of a percentage point to 5 per cent.

The Bank’s next scheduled date for announcing the overnight rate target is June 3.

Economists were split going into the Bank of Canada’s decision on interest rates today. Now they are puzzling over its next move.

“Factoring in the view that downside risks have subsided somewhat in light of more rapid and pervasive developments in Iraq than previously expected, this provided the Bank the final impetus it needed to move further along the path of monetary tightening,” says RBC Financial.

“The move had been increasingly factored into markets as geopolitical tensions have eased,” notes Bank of Montreal. “That said, the press statement suggested that the central bank’s concern about the economic outlook has increased a notch and its eagerness to continue tightening has diminished somewhat. This suggests that the Bank may stand pat at the next scheduled announcement date on June 3.”

RBC agrees with BMO, noting, “What may make for a more cautious central bank is that an appreciating Canadian dollar reinforces the cooling effects of rate hikes.”

BMO is calling for the Bank to sit tight at its next meeting, but to likely resume hiking rates after that. “With the Bank’s concern about the economic outlook raised a notch, it appears less eager to extend the tightening cycle in the near term.'”