TD Economics says that it can’t figure out why the Bank of Canada suddenly got so hawkish on interest rates. Nevertheless, it sees rates heading sharply higher this year.

“It came as a shock to see the Bank arguing in this week’s communiqué and Monetary Policy Report that inflation had risen by more than the Bank had expected” writes Craig Alexander, senior economist in the January 24 issue of The Bottom Line.

Alexander notes that shelter costs were up only 1.2% year-over-year in December, while food increased 2.2%.

Still, he observes that the Bank has upwardly revised its inflation forecast and believes it will have to raise interest rates sooner than it had previously thought. “Given the lag between changes in rates and their impact on demand and inflation, the Bank is signaling that it will have to act soon.”

Alexander writes that markets have now almost completely factored in a 25 basis point increase at the March 4 rate decision and assigned a more than 66% chance of another hike by June 3. “Given the Bank’s statements, we agree with the markets’ assessment. Indeed, it would be a little odd for the Bank to make such a strong case to tighten and then leave policy unchanged at the next meeting. Furthermore, there is very little Canadian economic data to influence the thoughts of the central bankers before March.”

Geopolitical events are a key wildcard, Alexander notes. He warns that the geopolitical risks may not be resolved by the Bank’s March policy meeting.

“In the final analysis, barring the outbreak of a war, the Bank is signaling that March is the most likely timing for it to resume tightening monetary policy. However, the Bank will take a gradualist approach, with rates increasing only in 25 basis point increments.”

Alexander concludes that “Over the course of 2003, we expect that the overnight rate will be increased by a total of 125 basis points (no change from our prior forecast), which is roughly 50 basis points more than markets are currently expecting.”