Economic growth and inflation in Canada in the first half of this year have been stronger than expected. the Bank of Canada said today in its July update to its monetary policy report.

Final domestic demand has remained the key driver of economic growth in Canada, bolstered by firm commodity prices. The central bank said economy is now operating further above its production potential than was projected at the time of its monetary policy report in April.

Both total CPI and core inflation have been higher than projected in April and are above the 2% inflation target, the bank said.

Longer-term interest rates have increased, and the Canadian dollar has appreciated sharply, moving well above the trading range assumed in the last report, the central bank noted.

The bank said the Canadian economy is now projected to grow by 2.5% in 2007, somewhat stronger than was expected in April, and to grow somewhat more slowly in 2008 and 2009 than previously projected.

In this new projection, higher interest rates across the yield curve and a higher assumed range for the Canadian dollar of US93¢ to US95.5¢ act to moderate growth in 2008 and 2009 to an average of about 2.%. “This brings aggregate demand and supply in Canada back into balance in 2009,” the bank stated.

Inflation is projected to be slightly higher and more persistent than in the April report. With the direct effect of the GST cut ending, and with the impact of the temporary decrease in gasoline prices in late 2006, total inflation is projected to peak at about 3% in the fourth quarter of this year. However, as excess demand diminishes, total CPI and core inflation should decline to 2% by early 2009.

There are both upside and downside risks to this inflation projection, according to the bank. “The main upside risk is that household demand in Canada could be stronger than expected. The main downside risks are related to the higher Canadian dollar and the ongoing adjustment in the U.S. housing sector. In the context of the bank’s new projection, these risks appear to be roughly balanced.”

On Tuesday, the central bank raised its key policy interest rate by one-quarter of one percentage point to 4.5%. The bank also noted that some modest further increase in the overnight rate may be required to bring inflation back to the target over the medium term.