* Annual inflation rate 3.7 pct vs 3.3 pct in April
* Inflation the highest since 2003; forecast 3.3 pct
* Monthly inflation 0.7 pct, forecast 0.2 pct
* Core inflation also higher than Bank of Canada forecast
* C$ strengthens on the news, bonds weaken
(Adds analyst and market reaction, graphic, details on core)
By Randall Palmer
OTTAWA, June 29 Canadian inflation rose to its
highest level in more than eight years in May, boosting the
Canadian dollar and raising the prospect the central bank will
raise interest rates sooner than previously expected.
Annual inflation hit 3.7 percent, well above expectations
and far above the Bank of Canada's 2.0 percent target,
according to Statistics Canada data on Wednesday.
Gasoline was the lead factor, but the core inflation that
the central bank follows closely also rose to 1.8 percent from
1.6 percent in April, well ahead of the 1.4 percent it had
predicted for the second quarter.
The month-on-month rise in overall prices more than doubled
to 0.7 percent from 0.3 percent in April. Analysts expected a
monthly rate of 0.2 percent, and saw the annual rate holding
steady at the 3.3 percent registered in April.
"This report will get markets thinking about a move by the
Bank of Canada sooner than they had previously anticipated,"
said Craig Alexander, chief economist with Toronto-Dominion
"Quite frankly, I think the BoC is still focused on the
economic risks. As a consequence, today's inflation report
doesn't change our thinking the Bank of Canada probably won't
move off the sidelines until January of next year."
Bank of Canada Governor Mark Carney signaled in an
interview last week that he might have to keep monetary policy
stimulative because of "substantial headwinds".
The next rate decision is on July 19, though most do not
expect a hike then.
Carney has said inflation "in the short term" would be
above 3 percent -- it has a target rate of 1 percent to 3
percent -- before returning to 2 percent by mid-2012.
For inflation graphic, click r.reuters.com/han42s
Scotia Capital economist Derek Holt pointed out that the
seasonally adjusted monthly rise was only 0.2 percent.
"Controlling for the seasonal adjustments and the clothing
component (which rose 2.0 percent on a seasonally adjusted
basis), I don't see much of a fanning out of inflationary
pressures here," he said.
Holt added that the decline in gasoline prices would temper
inflation in June. Gasoline rose 2.0 percent in May from April
and was 29.5 percent higher than May 2010. Excluding gasoline,
the consumer price index was still 2.4 percent higher in May.
Laurentian Bank Securities assistant chief economist
Sebastien Lavoie took a counter view. "It's a really
broad-based increase," he said.
The Canadian dollar CAD=D4 rose to a session high of
C$0.9696 to the U.S. dollar, or $1.0314, shortly after the
data, from C$0.9768, or $1.0238, immediately before.
Higher interest rates often support a country's currency
because they help attract international capital flows.
Overnight index swaps, which trade based on expectations
for the key central bank rate, showed that traders priced in an
increased probability of rate hikes later this year, though a
full quarter-point rate hike was not priced in until 2012.
BMO Capital Markets economist Robert Kavcic pointed out
that the core rate could be pressured higher still after June,
because of comparison with the year-earlier months, which had
mellow price increases.
The yield on the two-year Canadian government bond
CA2YT=RR, which is especially sensitive to Bank of Canada
interest rate moves, rose to 1.51 percent from 1.465 percent
just before the report. <0#CABMK=>
One technical factor in May's increases was a switch to a
new consumption basket, based in 2009, from the old 2005
basket. Using the old basket, monthly inflation would have been
0.6 percent and annual would have been 3.6 percent, a
Statistics Canada analyst said.
(Additional reporting by Ka Yan Ng, Solarina Ho and John Tilak
in Toronto; Editing by Jeffrey Hodgson)