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OTTAWA — The Bank of Canada signalled Tuesday it is about to bring its era of record-low interest rates to a close.

By Paul Vieira, Financial Post, April 20, 2010

In a decision that sent the Canadian dollar soaring more than 1.5 cents U.S., the bank ditched its conditional pledge to keep rates at 0.25 per cent until July, saying the recovery was proceeding more rapidly than expected, housing activity was "very strong" and inflation was expected to be stronger than previously anticipated over the next year.

"With recent improvements in the economic outlook, the need for such extraordinary policy is now passing, and it is appropriate to begin to lessen the degree of monetary stimulus," the bank said in its statement.

In the depths of the financial crisis a year ago, the bank pledged to keep rates at 0.25 per cent until July, conditional on the outlook for inflation.

While most Bay Street economists expect the bank to begin raising rates with a traditional quarter percentage point increase, some said a half-point hike was a possibility.

"Removing the conditional commitment . . . (is) as good as cementing a June 1 hike," said Derek Holt, vice-president of economics at Scotia Capital. "That leaves open the debate over whether 25 basis points or 50 basis points is likely."

Sebastien Lavoie, economist at Laurentian Bank Securities, said an initial 50-basis-point increase is the most likely outcome if the central bank "really wants to move away from unconventional policy. The bank doesn't want to fall behind the inflation curve."

A Reuters poll of Bay Street dealers forecast the overnight rate would range from 1.25 to two per cent by year's end. That reflects either a "steady diet" of 25-basis-point increases until the end of the year, as HSBC economist Stewart Hall expects, or one-shot 50-basis-point moves later in the year.

Brian Bethune, chief Canadian economist at IHS Global Insight, said the Canadian dollar's strength is likely to limit the Bank of Canada to one "token" rate hike of 25 basis points, and then wait until the U.S. Federal Reserve begins to bump up rates.

"I think the reality is they aren't going to need to raise rates that much," he said, "because with the Canadian dollar shooting to parity again, that's a significant deflationary force."

In its statement, the central bank upgraded its growth forecast for this year to 3.7 per cent from 2.9 per cent, which is above the Bay Street consensus. And it expects inflation, which guides rate decisions, to be "slightly higher" than the bank's preferred two per cent target over the next 12 months.

A rate hike in June would position Canada as the first among Group of Seven countries to begin raising rates.

Markets reacted by pushing up the loonie by nearly 12 basis points to above parity with the U.S. dollar, while bond yields climbed across the board — meaning recent hikes in mortgage rates are likely to stick and other increases are potentially in the offing for a series of loans and lines of credit.

The bank's decision to lay the groundwork for a return to more normal interest rates indicates it believes the global financial crisis is no longer the biggest risk to the economy.

"This is an abrupt and sudden change of tone from the bank," said Douglas Porter, deputy chief economist at BMO Capital Markets. "They are moving away from viewing the financial risks as being the biggest threat to the economy, to shifting their sights on what pace of tightening will have to unfold."

The bank's conditional pledge was established a year ago and meant to take the place of so-called quantitative easing — pumping billions of dollar into the marketplace through the acquisition of securities — that other central banks in developed economies were engaging in. There was talk that the bank would fulfil its conditional pledge or risk losing credibility.

However, one foreign-exchange analyst said the central bank's credibility is likely stronger as a result of its shift in direction.

"The Bank of Canada is not only demonstrating credibility in fighting inflation and managing sustainable growth, but also leadership in global financial markets and among international policy-makers," said Michael Woolfolk, senior currency strategist at BNY Mellon in New York.

While the statement acknowledges recent economic strength, some analysts say bank does highlight risks to its outlook, most notably the low-level of U.S. consumer demand, the country's relatively poor productivity performance and, of course, the elevated level of the Canadian dollar.

With files from Reuters