The Canadian economy has been stronger than projected and is now operating further above its production potential than had been previously expected, the Bank of Canada said today.

In its semi-annual Monetary Policy Report, the bank said Canada’s gross domestic product is projected to grow by 2.6% in 2007, 2.3% in 2008, and 2.5% in 2009.

Since its July update, the outlook for the U.S. economy has weakened, the central bank said. As well, he Canadian dollar has appreciated sharply, and credit conditions have tightened.

“Despite these tighter credit conditions, the momentum of domestic demand in Canada is expected to remain strong. The combined effect of a weaker U.S. outlook and a higher assumed level for the Canadian dollar implies, however, that net exports will exert a more significant drag on the economy in 2008 and 2009 than previously expected,” the bank said.

With the economy moving back towards balance, and with the direct effect of the stronger Canadian dollar on consumer prices, core inflation is projected to gradually decline to 2% in the second half of 2008.

The central bank said total CPI inflation is expected to peak at about 3% later this year and then move back down to the 2% target in the second half of 2008.

The bank noted a number of risks to its inflation projection. “The main upside risk is that excess demand in the Canadian economy could persist longer than projected. The main downside risk is that output and inflation could be lower if the Canadian dollar were to be persistently higher than the assumed average level of 98 cents U.S. for reasons not associated with demand for Canadian products,” the bank said.

The bank added that it “judges that the risks to its inflation projection are roughly balanced, with perhaps a slight tilt to the downside.”

The Bank of Canada on Tuesday left its key overnight policy rate unchanged at 4.5%.

Bay Street economists suggest the Bank of Canada is more worried about sustaining growth than stoking inflation — but economists don’t think the central bank is worried enough to cut rates anytime soon.

RBC Capital Markets says that the MPR reiterated that Canada’s economy was running deeper into a state of excess demand in the third quarter of 2007 than it had projected in its July Update and highlighted several upside and downside risks to the outlook for inflation. It adds that the Bank also mentioned the “modest tightening in credit conditions” as weighing on the outlook for growth but says that this will affect the growth outlook to a “much lesser degree” than the currency and the U.S. forecast downgrade.

The Bank cut its forecast for U.S. growth in 2007 and 2008 to 1.9% and 2.1%, respectively, from 2.1% and 3% in its July Update. The forecast for 2009 was unchanged at 3%.

It also revised the third- and fourth-quarter forecasts for Canada lower to 2.5% and 1.8%, respectively (from 2.7% and 2.6% in the July forecast). For the year as a whole, the strength at the start of the year resulted in the 2007 growth rate being raised to 2.6% from the 2.5% in July. The 2008 and 2009 growth forecasts were revised to 2.3% in 2008 (from 2.6%) and 2.5% in 2009 (from 2.4%). “The below-trend growth is expected to work off the excess demand currently in the system in early 2009,” it notes.

RBC says that the Bank, “sounded a slightly more benign note on the outlook for inflation, with both the core and total CPI rates expected to return to the Bank’s 2% target in the second half of 2008 rather than in early 2009 as stated in the July forecast.”

With this softer inflation outlook, and the accumulation of downside risks, RBC says that there’s some support for the view that the Bank will cut the overnight rate in the months ahead.

“However our assessment is that domestic demand will remain firm, backed by the improvement in the terms of trade, which will make it difficult for the Bank to lower rates without stoking the already-hot domestic economy and generating more upside pressure on prices,” it says. “On balance, our assessment is that the risks are more skewed toward slightly stronger growth next year, which should keep the Bank holding the policy rate at 4.5% for the next several quarters but eventually see the rate move up in late 2008.”

@page_break@BMO Nesbitt Burns indicates that it also reads the MPR as indicating that the Bank “is a wee bit more concerned about the downside risks to growth, than the upside risks for inflation, a 180-turn from their previous MPR.”

“While the Bank is officially a bit more concerned about the downside risk for growth, this de facto easing bias is unlikely to turn into outright cuts for some time yet. Their main concern seems to focus around the dollar, not the credit disruption,” it adds.