UPDATE 3-Bank of Canada cuts growth forecast, warns again of higher rates

Wed Apr 17, 2013 2:53pm EDT

* Maintains policy tightening bias despite slower growth

* Says economy won't return to full capacity till mid-2015

* Carney says economic slack is "not that big"

By Louise Egan and Randall Palmer

OTTAWA, April 17 (Reuters) - The Bank of Canada chopped its economic growth forecasts and welcomed signs of a cooler housing market on Wednesday as it left its benchmark lending rate unchanged and said it still expects its next move on interest rates to be up.

The central bank, the only one in the Group of Seven (G7) leading industrialized nations hinting at higher rates, held its main rate at 1 percent, where it has been since September 2010.

In the last Monetary Policy Report it will issue before Governor Mark Carney leaves to head the Bank of England in July, the bank sharply downgraded economic growth expectations and suggested that slack in the economy was still building.

It cut its 2013 growth outlook to 1.5 percent - the same as an International Monetary Fund forecast - from the 2.0 percent it saw in January. It forecast 2.8 percent growth in 2014.

Nonetheless, the central bank said it still expects interest rates to rise, repeating that after a period of time "some modest withdrawal" of monetary stimulus would likely be required.

Some analysts had speculated the central bank could water down or drop language about raising rates as the economy slows.

But Carney told reporters it is important to look at the context, including the fact that the benchmark rate is low, and the financial sector is functioning very well.

"There is slack in the economy. We call it material slack, but it's not that big, and it's certainly not that big relative to other major economies," Carney told a news conference.

The bank has been worried about the recent housing-market boom in Canada and about a surge in household debt, which critics say has been fueled by its ultra-easy monetary policy.

The housing boom slowed after the federal government tightened mortgage rules last year. But many think the central bank is reluctant to drop its tightening bias because it might help reignite the property sector.

Carney praised the "constructive evolution of the housing market", and said it will influence interest rates.

"We're encouraged by what we're seeing. That reality provides a longer horizon, a period of time before an adjustment would need to be made," he said.

Still, the central bank warned there were still some signs of overbuilding, particularly of multiple-unit dwellings in some cities, and that valuations in some segments were stretched.

Canada weathered the global recession better than most countries, and the Bank of Canada has eschewed the quantitative easing used by the U.S. Federal Reserve, the Bank of England and now, on an unprecedented scale, by the Bank of Japan.

But the economy has struggled recently, under pressure from slower growth in government spending, the slower housing market, a persistently strong Canadian dollar, and lower-than-expected business investment.

"Our view is that we're not going to see that acceleration in investment until we see that pickup in demand, the pickup that we're expecting," Carney said.

One bright spot is the U.S. housing recovery, which the bank projects will boost Canadian export growth by 1 percentage point per year.

The bank said the persistent strength of the Canadian dollar has curbed export growth.

It figured the economy's spare capacity grew to 1-1/4 percent in the first quarter, from the 1 percent it saw in January for the fourth quarter of 2012.

That means it will take longer for the economy to hit full capacity, and for total and core inflation to rise to the bank's 2 percent target. It now sees this happening by mid-2015, whereas in January it had predicted the second half of 2014.

"It likely pushes (an interest rate hike) out even further. It's likely we won't have higher rates in Canada until well into 2015," said Bank of Nova Scotia chief currency strategist Camilla Sutton.

Before Wednesday's statement, forecasters had tipped the third quarter of 2014 as the likely date for a rate hike.

Yields on overnight index swaps, which trade based on expectations for the policy rate, showed traders slightly scaled back their bets of a rate cut later this year.

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