The Canadian economy’s growth has been essentially in line with the Bank of Canada’s expectations set out in January Monetary, according to its April Montetary Policy Report, which was released on Thursday.

However, inflation has been higher than expected. After considering the full range of indicators, the BoC now judges that the Canadian economy was operating just above its production capacity in the first quarter of this year.

Over the projection horizon, domestic demand continues to be the main driver of growth in Canada. With the U.S. slowdown now expected to be somewhat more prolonged than previously projected, net exports should exert a slightly greater drag on growth in 2007. The Canadian economy is projected to grow by 2.2% in 2007 and 2.7% in both 2008 and 2009, returning to its production capacity in the second half of 2007 and remaining there through 2008 and 2009.

Core inflation should remain slightly above 2% over the coming months, given pressures on capacity and the impact of higher core food prices. But with the economy projected to return to its production capacity in the second half of this year and with further easing of pressures from housing prices, upward pressure on core inflation is expected to moderate, bringing core inflation back to 2% by the end of 2007.

Total CPI inflation is projected to rise above the 2% inflation target in the second half of this year, peaking below 3% near the end of 2007 before returning to the target by mid-2008.

The BoC continues to judge that the risks to its inflation projection are roughly balanced, although there is now a slight tilt to the upside.

On Tuesday, the BoC left its key policy rate unchanged at 4.25%. The current level of the policy interest rate is judged, at this time, to be consistent with achieving the inflation target over the medium term.

Today’s MPC report clarifies the bank’s thinking on the economy, but doesn’t change the prospect for rate moves, Bay Street economists say.

TD Bank reports that the Bank of Canada estimates that the economy has drifted into a position of excess demand, which fuelled an increase in core inflation above the Bank’s 2% target. “It will, however, be a relatively short stay, as further weakness in the United States will translate into sub-par economic growth in Canada, helping to pull the economy back towards its capacity over the course of the year,” TD says. “Core inflation will also ease, but take a touch longer, returning to target by year end.”

On the prospects for economic growth, the Bank left their forecast for real GDP growth essentially unchanged, TD says – shaving just a tenth of a percentage point from both 2007 and 2008 (the Canadian economy is now expected to increase by 2.2% this year and by 2.7% in 2008). “Domestic demand will remain in the driver’s seat, although it is expected to moderate somewhat from the rapid growth rate observed in previous years,” it says. “On the external side, the picture is mixed, with weakness in the U.S. economy offset to a certain degree by strong growth elsewhere in the global economy. Nevertheless, the anticipated softness in the U.S. economy was deemed to be sufficient to eventually pull the overall economy back towards its productive capacity.”

“At the end of the day, it is difficult to argue with the Bank’s assessment of the Canadian economy. There appears that another shoe is beginning to fall in the U.S. housing market and emerging concern about the business sector could spill over to the broader economy. Meanwhile, Canada’s domestic economy continues to be well supported by very strong fundamentals,” TD concludes. “While the Bank sees the risks remaining roughly in balance, we would argue that the timing of the risks suggests more of a tilt to the upside. For example, it would take an extended period of U.S. weakness to open the door to rate cuts, while only a couple more months of elevated inflation or tightening capacity could warrant a hike.”

BMO capital Markets says that, “While the Bank is now officially a bit more concerned about the upside risks to inflation, today’s MPR sends no obvious distress signals on that front.”

“There is no particular sense of urgency, and the Bank doesn’t seem overly concerned by the call that headline inflation will approach 3% by late 2007, or that core inflation will stay north of the 2% target for most of the year. They may have a hawkish tilt, but it is very mild,” BMO finds. “We continue to expect the next move by the Bank to be a rate hike, although the bar for any action has clearly been set very high.”