WRAPUP 2-Bank of Canada under pressure as inflation at 27-month high

Fri Jun 20, 2014 2:23pm EDT

* Overall inflation 2.3 pct in May, core 1.7 pct

* Economists expect less BoC talk about weak inflation

* Rate hike seen sooner than later - but not now

* C$ rises to five-month high, bonds sharply lower (Recasts with analyst comment, context about pressure on central bank, market reaction)

By Randall Palmer

OTTAWA, June 20 (Reuters) - The Bank of Canada came under pressure on Friday to stop fretting about low inflation after unexpectedly sharp price gains pushed the rate above the central bank's target, making it more likely the next move in interest rates will be higher.

Statistics Canada reported the annual inflation rate hit a 27-month high of 2.3 percent in May from 2.0 percent in April. Core inflation, which excludes some volatile items like gasoline, rose to 1.7 percent, the highest since July 2012, from 1.4 percent in April.

As recently as last week, Bank of Canada Governor Stephen Poloz had said the underlying rate of inflation, which he pegged at 1.2 percent, was so low it "leaves us vulnerable to a downside shock at any time."

The central bank aims for 2 percent inflation and to keep it within a range of 1 to 3 percent. While acknowledging higher inflation readings in its June 4 rate statement, it said increased risks to growth left "the downside risks to the inflation outlook as important as before."

But economists said on Friday that position was becoming increasingly untenable and said a change in language would be in order, though nobody expects an immediate rate hike.

"The low-inflation ship has sailed in Canada, and I think the Bank of Canada pretty much has to change their rhetoric as of the next meeting," said Bank of Montreal chief economist Doug Porter.

It may be tricky for the central bank to shift its tone without at the same time causing a strengthening in the Canadian dollar that would hurt exports, similar to sterling's strong rise when Bank of England Governor Mark Carney said last week rate hikes could happen sooner than expected.

National Bank Financial senior economist Krishen Rangasamy believes the Bank of Canada, formerly headed by Carney, will want to downplay inflationary pressures and reductions in the output gap "so as to keep the Canadian dollar weak."

"I think they are going to keep spinning that story as long as they can, to keep the Canadian dollar from heading back towards parity. They definitely do not want that to happen because that could choke off the recovery in exports," he said.

Poloz has repeatedly said the central bank targets inflation and not the currency, but has also expressed disappointment with export growth.

The Canadian dollar rose to a 5-1/2 month high on the inflation data, and on an accompanying report showing retail sales in April rose nearly twice as fast as expected.

Canada was the first among the Group of Seven leading industrialized nations to raise its policy rate after the 2008-09 recession but has kept it at 1 percent since September 2010.

Poloz has said the central bank's policy stance was neutral, specifying that rates could just as easily fall as they could rise, using dovish language that has kept a lid on rate hike expectations and the currency.

Still, yields on overnight index swaps show rate cut expectations have largely faded.

And even before Friday's data economists were unanimous that the next rate would be a hike.

MAKEUP OF INFLATION

The median forecast in a Reuters poll of 38 economists released on May 29 was for the Bank of Canada to raise its rate in the third quarter of 2015, with no one expecting a hike this year.

"We are still of the view that any moves on rates are not likely until 2015, but certainly there is now a higher probability of hikes coming sooner rather than later," said Royal Bank of Canada assistant chief economist Paul Ferley.

May's inflation readings were well above the second-quarter projection the Bank of Canada made in April of only 1.6 percent overall and 1.2 percent for core.

Last month's inflation rate also was the highest since the 2.6 percent reported for February 2012.

The year-over-year rise in prices was led by an 8.4 percent jump for energy, including 6.3 percent for gasoline, 21.3 percent for natural gas and 7.0 percent for electricity.

Porter said the bank believed the drop in the Canadian dollar over the past year might have added 0.2 percentage points to core inflation recently.

"I think there is more to this than just food, energy and the Canadian dollar. I do think inflation is starting to creep back up again," Porter said.

Indeed, the monthly rise in core inflation was identical to the rise in overall prices, 0.5 percent. (Additional reporting by Allison Martell, Euan Rocha and Alastair Sharp in Toronto; Editing by Jeffrey Hodgson and Paul Simao)

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