Today’s update to the Bank of Canada’s Monetary Policy Report confirmed that interest rates will be heading higher in the short term, although the central bank’s move to cut output estimates has economists wondering how long before it must reverse course again.

Bank of Montreal says that the MPR “reaffirmed the view that interest rates will be rising in the months ahead, albeit at a measured pace”. It notes that the strong Canadian dollar and still contained inflation pressures “point to a gradual, rather than aggressive, course of tightening”.

The central bank reduced its outlook for economic growth next year as a result of the recent further appreciation of the Canadian dollar, BMO notes. It now expects annual growth in real GDP of 2.9% in 2006, down from 3.3% previously estimated in the July MPR Update. The Bank of Canada also sees the Canadian dollar trading in a range of US84¢ to US86¢ through 2007.

BMO Nesbitt Burns adds that the Bank also reduced its estimate of current potential GDP growth (to 2.5% from 3%), “a move we have been anticipating for quite some time because of weak productivity trends”.

Nesbitt sees a mixed message in the MPR, “Note that while the Bank continues to assert that the risks to growth are tilted to the downside in 2007 and beyond, they are nevertheless projecting a pick-up in GDP growth that year to 3.0%.”

TD Bank agrees that the case for higher interest rates in the near term remains compelling. “However, what goes up must come down,” it points out. “Based upon the Bank of Canada’s medium- and long-term outlook, it seems equally clear that interest rates could decline in late 2006.”

Along with lowering growth estimates, TD notes that the Bank “continues to drive home the point that there exist asymmetric risks to 2007 and beyond, with the greater probability lying on the downside”. The principle risk is that when the savings rate of U.S. households and the government finally begin to rise, domestic demand elsewhere in the world may fail to pick up sufficiently to sustain global demand. As a result, it suggests that the overnight rate could begin to fall as early as the third quarter of 2006.

National Bank Financial maintains that the risk might be more eminent than the Bank assumes. “Indeed, the latest Beige Book suggests that the U.S. housing market is already slowing in some regions. This, against a backdrop of high energy costs and rising interest rates that are likely to push the sum of debt service payments and the energy bills relative to disposable income to a level not seen since the early 1980s.”

“With U.S. consumers no longer in a position to remain the world’s growth locomotive, the Canadian economy will also suffer. In our opinion, the Bank of Canada may very well be pushed back to the sidelines as early as the second quarter of 2006,” it says.