The Canadian economy continues to grow at a solid pace, supported by robust global growth, firm commodity prices, and strong domestic demand. At the same time, global competition and the past appreciation of the Canadian dollar continue to pose challenges for a number of sectors. All factors considered, the Canadian economy is judged to be operating at, or just above, its production capacity.

That’s the message from the Bank of Canada in its April Monetary Policy Report, which was released today and discusses current economic and financial trends in the context of Canada’s inflation-control strategy.

The Bank projects economic growth of 3.1% in 2006, 3% in 2007, and 2.9% in 2008. Total CPI inflation will continue to be volatile and affected by developments in the markets for crude oil and natural gas.

The Bank projects that the total CPI will average close to 2% in 2007 and 2008 — excluding the effect of any changes in the GST. Core inflation is projected to rise to 2% in the second half of this year and remain there through the end of 2008.

There are both upside and downside risks to the Bank’s outlook for growth and inflation. The Bank judges that these risks are roughly balanced, with a small tilt to the downside later in the projection period.

On 25 April, the Bank raised its target for the overnight rate to 4%. In line with the Bank’s base-case projection and current assessment of risks, some modest further increase in the policy interest rate may be required to keep aggregate supply and demand in balance and inflation on target over the medium term.

The Bank will closely monitor evolving developments in the Canadian economy in light of the cumulative increase in the policy interest rate since last September.

Meanwhile, Economists say that today’s Monetary Policy Report confirms that rates are going higher.

Bank of Montreal notes that the Bank of Canada has upped its growth forecast modestly, and believes the economy will operate slightly above its production capacity to the end of 2008. As well, the Bank is somewhat less concerned about the downside risk posed by an unraveling of global imbalances, it adds.

The Bank of Canada’s annual GDP growth projections for 2006, 2007 and 2008 are weaker in profile than BMO’s projected rates of 3.5%, 3.3% and 3.1%, respectively. “The implication is that, whatever the Bank currently plans to do on the rate front, it will likely be compelled to increase further if growth comes in as we anticipate,” it says. “For now, the Bank appears to be leaning towards one more move, but we believe it will need to move a couple more times up to 4.50%.

“Though our current forecast sees the Bank gradually reaching this near-term peak by October, it is becoming increasingly likely that another move will be undertaken at the next fixed announcement date on May 24, and likely again at the subsequent announcement date on July 11. Therefore, the projected peak in rates could be reached by the summer instead of the fall,” it concludes.

TD agrees that the odds clearly favour the Bank of Canada raising the overnight rate by a quarter point on May 24 to 4.25%. This is a change in view for TD Economics, which has been arguing for some time that the peak would be at 4%. “While we believe that the Bank should pause at this time, the forecast has to reflect what the Bank is signaling they are intending to do,” it says.

“The real question is the balance of risks to inflation. In our opinion, unless there is significant increased pass through from elevated energy prices, inflation is likely to remain subdued. This is why we believe that the Bank should leave rates on hold. However, the Bank may disagree,” TD says. “Indeed, the MPR suggests that the disinflationary effect of cheap foreign imports on Canadian inflation may wane as stronger global growth puts pressure on world production capacity. So, based on the content of the MPR, we must presume that the overnight rate will rise to 4.25% on May 24 and assume that will be the peak in rates – at least until the Bank tells us differently.”

BMO Nesbitt Burns says: “This report appears no more hawkish than Tuesday’s statement, and actually sounds quite calm about the inflation outlook even with the slight rise in the core CPI outlook for this year. Still, the Bank leaves little doubt that they remain biased to tighten, particularly with the economy operating above capacity. The renewed and rapid rise in the Canadian dollar may ultimately do much of that tightening for the Bank, but we look for at least one more rate hike this year.”