Expectations that the Bank of Canada will begin raising interest rates this summer are on the mark but investors shouldn’t be surprised if rates remain very low by historical standards right through 2011, according to a report released Thursday by CIBC World Markets Inc.

While markets may be aggressive in their expectations for rate hikes after the first increase expected in July, “a gradualist approach” is more likely and could see overnight rates at a still-low 2.5% at the end of next year, says Avery Shenfeld, CIBC’s chief economist, in the report.

Shenfeld lists several reasons for Bank of Canada governor Mark Carney to “take it easy” on rate hikes after July.

Shenfeld says the long path to sustained growth in the United States means an interest rate hike there is likely several quarters away. “Why should Governor Carney care about getting too far ahead of the U.S. Federal Reserve (in raising interest rates)?”

Unmatched rate increases in the U.S. could also “send the Canadian dollar into record territory,” he adds.

The recent uptick in inflation is not expected to continue as Canadian production is below its potential, Shelfeld notes. This “output gap” serves to restrain wages and other costs, ultimately reducing the need to hike rates to curb inflation.

The removal of stimulus spending will also but the brakes on inflation. Federal and provincial belt tightening beginning in 2011 “could take a huge slice off next year’s growth rate. If so, overnight rates might have to remain stimulative, as rates at 2.5% or less would be,” says Shenfeld.

In addition, austere foreign budgets will likely impede global growth. “If the U.S., the U.K., and Japan all move from huge stimulus to even modest restraint, Canada will feel it in our export prospects come 2011,” Shenfeld says.

Shenfeld adds that banking reforms in G20 countries require added capital and reduced leverage that will cut into global bank lending capacity. “The more credit tightens due to regulatory actions, the less need for central banks to do it through the overnight rate,” he says.

A gradual tightening of rates may indeed be good for Ottawa and provincial governments which, as noted elsewhere in the report, are expected to borrow money at elevated levels through 2011 via new bond issuance.

For equity investors, CIBC World Markets says higher interest rates are likely to slow rather than kill the current commodities rally. Oil and Industrial metals may even continue to rise as the report notes in past cycles after monetary restraint.

IE