The Bank of Canada and investors are underestimating the prospects for the Canadian economy this year and interest rates are headed higher than expected, say economists at Merrill Lynch (Canada).

In a research note released Friday, Merrill says that “the relationship between Canada and U.S. GDP growth has returned to normal, suggesting that as the US.S.economy goes so too will the Canadian economy.”

If the United States manages more than 3% growth this year, as expected, Canada should too. Merrill notes this is “considerably higher than current consensus and Bank of Canada predictions.”

Currently, the central bank is forecasting GDP growth of just 2.4% for Canada in 2011, versus 3.3% for the U.S. “This is the widest spread between Canada and the U.S. of any private or public sector forecaster, suggesting the BoC is the most pessimistic on headwinds for Canada — namely the strength of the Canadian dollar,” Merrill says. “We think the BoC is considerably underestimating the near-term growth prospects for Canada.”

“We also think Canada core inflation will rise by more than the market currently expects and move above the BoC’s 2% inflation target,” Merrill says, noting that the core consumer price index for Canada “is extremely vulnerable to commodity price shocks”, adding, “The most direct threat to core CPI is agricultural prices, which are up more than 30% over last year.”

With stronger growth and inflation, Merrill says that interest rates will continue to normalize faster in Canada than in the U.S. “We continue to expect rate increases in Canada, perhaps starting at the next policy announcement on March 1, and a 2.50% overnight rate by the end of the year,” Merrill says.

IE