Canadian gross domestic product came in weaker than expected in the fourth quarter, dropping to 1.6% from 3.6% in the third quarter. The report raises the question of whether interest rates can go higher as economic growth lags.

Bank of Montreal says that the main downside surprises in the report were in exports, which fell 8.0% in the quarter. The slowing in the U.S. economy, particularly for consumption of motor vehicles, was an important factor in the decline as well.

Also disappointing were declines in both non-residential investment and machinery and equipment investment. “The decline in the latter was particularly discouraging as this component had shown increases in the first three quarters of the year.”

“If the Bank of Canada is hoping to slow the economy to quell inflation, perhaps it could take a look at just how slow things already are,” says CIBC World Markets. “While at this point, one might argue that the economic softness in Canada is narrowly based, how much longer can domestic demand remain so buoyant in the face of a sustained cooling in manufacturing, a key cyclical driver?”

RBC Financial takes a more bullish view. “At first glance, the fourth quarter 2002 GDP report will give those believing that the Bank of Canada should act early to raise rates cause for reconsideration. However, the details of the report suggest that the Canadian economy remains in better form than that conveyed by the headline print on GDP today,” comments RBC.

CIBC concedes that Canadian consumers, well supported by 2002 job growth, are still spending. However, businesses remain very cautious about spending, despite a healthy recovery in profits. “The soft end to Q4 activity doesn’t bode well for much of a rebound in Q1 although a recovery in U.S. factory activity will likely put exports on a better footing,” says CIBC. “The Bank of Canada will have a tougher selling job if it moves to hike rates next week, since it’s less evident that the economy needs that additional braking force.”

BMO Nesbitt Burns agrees that this report complicates life even more for the Bank of Canada and their decision next week. “The latest inflation results scream ‘Hike’ and the latest growth figures shout ‘Hold’. Ultimately, the Bank’s job is control inflation, and that is likely to carry the day next Tuesday,” it says

“We believe that with the weak points of this report expected to be partly reversed in the near future and consumers’ balance sheets improving, the Bank of Canada will opt for a 25 basis-point rate hike next Tuesday in what is shaping up to be one of the most watched and hardest decision for the central bank since adopting inflation targets,” comments RBC.

TD Bank argues that today’s report has few implications for Bank of Canada policy. “While fourth-quarter growth was unquestionably weaker than the Bank was expecting, third quarter growth was revised up by half a percentage point to 3.6% – leaving the Bank’s measure of the output gap exactly where it expected it to land. In other words, the fourth quarter is history, and unless the Bank adopts a much more bearish take on the economic outlook, its concerns about inflation will remain very much alive.”

Bank of Montreal appears to be taking amore cautious approach. “The near-term growth outlook in Canada is further clouded by the increasingly likely military strike against Iraq that could have a downward impact on the US economy in the face of rising oil prices and falling confidence,” it says. “We lean towards these latter factors dominating the discussions at the Bank, resulting in interest rates holding steady at next week’s announcement.” Assuming that the geopolitical environment stabilizes by the end of March, Bank of Montreal expects the Bank of Canada to commence tightening April 15.