Economists at Morgan Stanley are raising their outlook on the Canadian economy, and forecasting the Bank of Canada won’t be able to keep its promise on interest rates.

The firm’s analysts say that after eking out a small gain in growth domestic product in the third quarter it is looking for Canada’s GDP growth to accelerate in 2010.

“From our perspective, both growth and inflation risks lie north of the Bank of Canada’s current forecasts,” it says. And, as result, it doesn’t believe that the Bank will be able to keep its promise to leave rates unchanged through the first half of next year. “We believe that the bank will need to hike before its conditional commitment to keep rates low until June 2010, and before the Fed,” it adds.

It is forecasting the first rate hike from the Bank of Canada in April 2010, coincident with the release of the Monetary Policy Report.

“[Third quarter] growth was something of a disappointment, but since then, we have seen consistent improvement in the domestic data that make us optimistic about the trajectory ahead. We look for a sharp pick-up in GDP in Q4 to give way to above-trend growth throughout 2010,” it says.

And, it expects consumer spending to lead the way. “Economic growth is shifting from being export-driven to relying more on domestic demand. In that regard, the Canadian consumer is well poised to carry the baton of growth,” it says noting that the labour market is showing signs of recovery, the housing market is stronger than in the US, and the equity market as turned around too. “Taking these factors into account, we believe that personal net wealth should continue to grow and drive final domestic demand higher in the coming months,” it says.

As growth picks up, inflation will too, Morgan Stanley says, and it forecasts CPI to return to the 2.0% target by the third quarter next year, a faster normalization than what the Bank of Canada forecasts.”We are already seeing a re-emergence of price pressures,” it notes.

“Based on our assessment of growth and inflation, we believe that the BoC will need to begin removing excessive monetary stimulus before June 2010. We expect a hike at the April 2010 meeting, which coincides with the release of the Monetary Policy Report that gives the bank an opportunity to justify a policy change,” it says, noting, “This is an out-of-consensus call, with the forwards curves only pricing in about a 30% probability of a hike in April.”

Following the first hike, the firm expects the Bank to “normalize rates rapidly” to reach 2.25% by the end of 2010.

“CPI will be the key guidepost to monitor,” it says. “Although the Bank continues to reiterate its commitment to low rates for now, the current stance is completely contingent on the inflation risks, which are shifting, in our view. If Q4 CPI ends up surprising above the bank’s forecasts, the bank will need to revise its outlook and remove accommodative policy sooner,” it says, pointing out that the next MPR Update is due on January 21, 2010.

The main risks that the firm sees to its forecasts, include: slower global growth, slower U.S. growth, commodity prices, and weak productivity growth.

IE