Source: The Canadian Press

The Canadian economy is hot and Canadians may have to pay for it in the form of higher borrowing costs.

The country’s gross domestic product expanded by a decade-topping 6.1% annualized in the first three months of 2010, ending the period on an upswing with a strong March result. Both the quarter and March results beat expectations.

The two data points are likely all the evidence Bank of Canada governor Mark Carney needs to pull the trigger Tuesday on the central bank’s first interest rate hike in about three years, taking the policy rate from the current record low of 0.25% to half a per cent, economists and markets believe.

“The domestic case for a rate hike is overwhelming,” said Douglas Porter, deputy chief economist with BMO Capital Markets, adding that the only doubt comes from uncertainty over the European debt crisis.

The past six months have shown the Canadian economy sprinting out of recession with 4.9% growth in the fourth quarter of 2009 and now an even greater expansion in the first quarter of 2010. Meanwhile, Canada’s underlying inflation is already close to Carney’s 2% target.

The employment rebound has been almost as impressive. The labour market has already recouped about 70% of the jobs lost during the 2008-09 slump, with new figures for May to be released Friday.

As well, the last few days have seen financial and equity markets stabilize after a hectic couple of weeks during which Europe’s debt crisis appeared to shake the confidence of investors.

Given the improvements, there is no more need for a policy rate hovering around zero, say economists, although they add it’s likely Carney will proceed cautiously.

“Clearly the Canadian economy doesn’t warrant interest rates of 0.25,” said Craig Alexander, chief economist with TD Bank.

“But this isn’t the Bank of Canada tapping on the brakes, it’s them pushing less hard on the accelerator. Short-term interest rates in Canada are still going to be at hyper-stimulative levels.”

Alexander said a neutral level for the overnight rate is in the 3.5 to 4% range.

A policy rate hike Tuesday will likely result in comparable increases to the prime rate and variable mortgage rates charged by Canada’s chartered banks and other lending institutions. But given recent weakening in bond yields, longer-term fixed mortgage rates may be unaffected initially, analysts said.

Investors also judged that the likelihood of a rate hike had firmed, pushing up the Canadian dollar close to a cent to 95.89 cents US in early trading. It held its value most of the day and closed at 95.83.

The big unknown _ which is why analysts expect Carney to proceed in small, incremental steps to tighten monetary policy _ is whether there are more shoes to drop in Europe and how that will impact global financial markets.

On Monday, the European Central Bank warned of potential bank losses of close to 200 billion euros over the next 18 months. Even if no crisis emerges, analysts expect the global recovery to moderate as many governments in Europe move to cut spending in the face of unsustainable deficits and debt loads.

Even in Canada, the domestic economy is unlikely to keep up the current torrid pace. The housing market is already showing signs of slowing, and consumer spending, which has been strong, is likely to slow given that household debt is already at record levels.

Some of the first-quarter expansion was due to firms rebuilding their inventory base, a short-lived phenomenon that pushes up growth in the early stages of a recovery.

Many analysts see the economy slowing to about 4% growth in the current second quarter, and perhaps to about 2.5% the rest of the year.

That should be reason enough to stay Carney’s hand, said labour economist Erin Weir of the United Steelworkers, who said any hike will likely push the Canadian dollar higher, hurting exports and the economy further.

But others, notably Scotiabank’s Derek Holt, says more moderate growth should check Carney from moving too fast on rate hikes, not from acting altogether. He predicted the overnight rate will be at about 1% by year’s end, still a relatively low level.

Analysts noted that even if a slowdown happens in the latter half of this year, it would still leave the economy ahead of where many had expected it to be a few months ago.

“No matter what else is going on in the world, and there is lots, we have a pretty solid and well-balanced economic recovery going on,” said economist Peter Drake of Fidelity Investments Canada. “When you look at the components of growth, I don’t think you see anything that sticks out and says, ‘Oh, my goodness, that just can’t last.’”

Statistics Canada’s report on GDP on Monday showed all industries advancing in the quarter, with strong results for consumer spending, housing, manufacturing and business investment in machinery and equipment.