UPDATE 3-Bank of Canada drops rate-hike talk, sees slower growth

Wed Oct 23, 2013 2:55pm EDT

* Omits rate-hike mention for first time since April 2012

* Sees rising risk from persistently weak inflation

* Sees delay in inflation returning to 2 percent target

* Downgrades growth projections across the board

* C$ sinks on news, fixed-income market rallies

By Louise Egan and Randall Palmer

OTTAWA, Oct 23 (Reuters) - The Bank of Canada has abandoned 18 months of warnings that interest rates will one day have to rise, saying on Wednesday that a soft economy and persistently weak inflation mean there is as much chance of a rate cut as a rate hike.

The surprise policy shift, which knocked the Canadian dollar to a one-week low and sent bond prices higher, came in a statement in which the central bank kept its key rate at 1.0 percent and dropped any hint of an eventual rate increase.

The bank had been signaling since April 2012 that borrowing costs would have to rise. It was the only central bank in the Group of Seven major economies to take that stance.

It now forecasts that inflation, which has been below the bank's 2 percent target for the past year and a half, will take six months longer than it had anticipated to return to target. The bank now expects that to happen at the end of 2015.

The decision to remove the reference to rate increases comes after the U.S. Federal Reserve surprised markets in September by maintaining its stimulative bond-buying program due to concern about the U.S. economic outlook. The United States is by far Canada's biggest export market, and the Bank of Canada noted growth there has been slower than expected.

"Uncertain global and domestic economic conditions are delaying the pick-up in exports and business investment," Bank of Canada Governor Stephen Poloz told reporters. "This leaves the level of economic activity lower than the bank had been expecting."

Poloz added that the bank was more concerned than before about the risk of persistently low inflation. But he also said that that danger, which might encourage a rate cut, is balanced by the record-high levels of personal debt that Canadians have taken on in an era of ultra-low rates.

The governor, presiding over his third rate decision since taking the bank's helm in June, said the bank's next move would depend on how the economy performs.

Asked whether the risk was balanced between a rate cut and a rate hike, he said: "Essentially that's correct, that's offering up a balanced perspective on where we stand today. We believe those risks are balanced as we sit here."

NEUTRAL BIAS

Still, most economists say there would have to be a significant shock for the bank to ease policy. Sal Guatieri, senior economist at BMO Capital Markets, said the bank is offering an even chance of a rate cut or hike in the short term, but that he thinks the bank still sees hikes on the horizon.

"Essentially what they've done is move from a very mild, longer-term tightening bias to a neutral bias," he said.

"We think the risks are fairly balanced over the next year or so, but we still believe the next move in rates will be an increase, although not until the first quarter of 2015."

Overnight index swaps, which trade based on expectations for the central bank's policy rate, showed traders slashing their bets that rates will rise late next year and pricing in a small chance of a cut before then.

The Canadian dollar weakened to a one-week low against the U.S. dollar after the statement. The currency was at C$1.0373 versus the greenback, or 96.40 U.S. cents, in early afternoon trade, weaker than Tuesday's close of C$1.0289, or 97.19 U.S. cents.

DISAPPOINTMENT

Canada's economy bounced back relatively quickly from the 2008-09 recession, but growth has been powered largely by consumer spending and a heated housing market

Poloz, who left his job as head of the country's export development agency to head the central bank, had initially been optimistic that exports, and then business investment, would take up the baton. He acknowledged this month in Washington that the performance of both has been disappointing.

The bank said weakness in the economy means it won't return to its full production capacity until the end of 2015, the same timetable it set for inflation returning to target.

The median forecast by more than 30 analysts in a Reuters poll last week was for the bank to start raising rates in the fourth quarter of 2014. Of those who perceived the bank to have a tightening bias, none expected it to drop that bias or to forgo a nod to a future rate increase.

"A move wasn't viewed as imminent, but that policy statement pushes out any expectation of any rate hikes further into the future, and that weighs on the Canadian dollar," said Paul Ferley, assistant chief economist at Royal Bank of Canada.

The central bank, as telegraphed in an earlier speech, cut its growth estimates across the board. It reduced its third-quarter growth forecast to an annualized 1.8 percent from 3.8 percent; fourth quarter to 2.3 percent from 2.5 percent; and growth for 2014 to 2.3 percent from 2.7 percent.

The bank also cut its outlook for U.S. growth in the second half of this year. Its overall forecasts for global growth were little changed due to positive surprises in the euro zone, Japan and China, but it said the composition of that growth was slightly less favorable to Canada, which ships most of its exports to the United States.

Despite its expectation for a soft landing in the housing market and a stabilization of household debt, the bank highlighted the risk of a housing correction if the market strengthens further because of low borrowing rates.

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

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