UPDATE 2-Bank of Canada holds rates, signals no rush to follow Fed

Wed Sep 4, 2013 1:26pm EDT

* Bank of Canada holds key rate at 1 pct, as expected

* Says growth in exports, business investment delayed

* Says household sector evolving constructively

By Louise Egan and Randall Palmer

OTTAWA, Sept 4 (Reuters) - The Bank of Canada held its key interest rate steady on Wednesday but signaled it has concerns about global economic uncertainty and the health of the country's export sector, suggesting it is in no rush to follow the U.S. Federal Reserve in altering monetary policy.

In a statement accompanying its widely expected rate decision, the central bank repeated its vague tightening bias, pointing to higher rates somewhere on the horizon. But it also highlighted the slack in Canada's economy and muted inflation, and cited signs of improvement in household debt and in the housing market, all of which suggested such a move is some way off.

By contrast, forecasts are for the Fed to start scaling back its bond purchases soon as a first step towards eventual rate hikes.

The Bank of Canada was the first Group of Seven central bank to tighten policy following the global financial crisis, hiking its main interest rate three times in 2010 to the current level of 1 percent. It has since kept to the sidelines. Economists surveyed by Reuters in late August expected the bank to resume raising rates in the fourth quarter of 2014.

The bank said on Wednesday its outlook for the domestic and global economies is largely unchanged from July. Yet it noted "less momentum overall than anticipated" in the U.S. economy.

Analysts saw a slight dovish slant in the bank's wording, but doubted there would be much change in terms of a timetable for eventual rate hikes.

"On the margins, it was a bit on the dovish side, but really it's steady as she goes," said Andrew Kelvin, senior fixed income strategist at TD Securities.

The bank predicted the economy would begin to absorb excess slack in 2014, puzzling some economists who had seen that process beginning later this year, based on the bank's own growth forecasts in July.

The bank believes the economy must grow by more than 2.1 percent to narrow the output gap - the difference between how much the economy produces and its potential production. In July, it projected third- and fourth-quarter growth at 3.8 percent and 2.5 percent, respectively.

"Realistically, if you look at their most recent quarterly forecast ... they had suggested it would begin to narrow in the second half of this year, so maybe at the margin slightly dovish, but mostly in line with expectations," said Mark Chandler, a fixed-income and currency strategist at Royal Bank of Canada.

EXPORT COMEBACK DELAYED

The bank also noted that exports and business investment, which it sees as key ingredients for a full economic comeback in Canada, have not yet replaced consumers as the main engine of growth as it had hoped.

"Uncertain global economic conditions appear to be delaying the anticipated rotation of demand in Canada towards exports and investment," the bank said.

Consumer spending and a frothy housing market powered Canada's quick recovery from the 2008-09 recession but now policymakers, worried that Canadians are taking on too much debt, are looking to exporters and corporations to take the reins.

"Perhaps for Canada the important thing here is that the so-called great rotation from consumer spending and housing to business investment and exports has disappointed the bank," said Doug Porter, chief economist at BMO Capital Markets.

"That came through loud and clear in the second quarter numbers," he said.

The lack of major surprises in the statement was seen as neutral for the Canadian dollar, which nonetheless strengthened after the release of the bank statement as it caught up with other currencies rallying on upbeat global economic data.

It was trading at C$1.0487 versus the U.S. dollar, or 95.36 U.S. cents, at about 12:50 a.m. (1650 GMT), firmer than Tuesday's North American finish of C$1.0530, or 94.97 U.S. cents.

As Fed officials talk of scaling back the U.S. central bank's $85 billion-a-month bond purchasing program, possibly as soon as September, the market reaction is being felt in Canada.

Since the Bank of Canada's July statement, the Canadian dollar has weakened against the greenback, which should benefit hard-hit exporters. But five-year bond yields have increased, pushing mortgage rates higher and potentially cooling the housing market.

Bank of Canada Deputy Governor John Murray said last month the net effects on Canada of Fed "tapering" would be positive.

While Canada's housing market has been stronger than anticipated, the strength has been tempered by slower credit growth and higher mortgage rates, the bank said, signaling no major concern on that front.

A couple walks along the rough surf during sunset at Oahu's North Shore, December 26, 2013. REUTERS/Kevin Lamarque

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