RBC Sees Canada Economy Slowing, Rate Hike in '08

OTTAWA (Reuters) - Canada's economic growth will slow more than previously thought in the fourth quarter but not enough to stop the Bank of Canada from resuming interest rate increases late next year, the Royal Bank of Canada forecast on Friday.

In its quarterly outlook, RBC cut its fourth-quarter growth forecast to 2.5 percent from 3.3 percent, citing an economic slowdown in the United States, a strong Canadian dollar and credit market tightness.

The economy grew an average 3.5 percent growth in the first half, fueled by high commodity prices.

The drag on growth in the coming quarters will be offset by strong demand for Canadian commodities from China and other fast-growing economies and a continuation of robust consumer spending and business investment.

"Canada's economy expanded at an above-potential pace in three of the past six quarters, leaving the economy in a state of excess demand," the report said. "Our growth forecast will result in only a modest easing in demand, which will keep upward pressure on prices."

RBC had forecast in June that the Bank of Canada would raise its overnight target rate to 5.25 percent by the first quarter of 2008 to bring inflation to its target level of 2 percent. The rate now stands at 4.5 percent.

It now sees the bank moving more slowly, keeping rates on hold until the fourth quarter of 2008, when it would resume tightening credit conditions with a 25 basis-point hike.

The bank raised its rate by a quarter-point in July but in subsequent statements it refrained from any talk of further increases, saying it needed to assess the impact of global credit market turmoil on Canada's economy.

"As the risks from the recent financial market volatility dissipate, as we expect next year, the bank is expected to return to tightening mode," RBC said.

Even so, the report said, the Canadian dollar's strength will do much of the tightening by holding down the cost of imported goods for Canadian businesses and consumers.

The strong currency will help push down the core inflation rate, which guides the bank's monetary policy, to 2.1 percent next year from an expected 2.3 percent this year, RBC said. Core inflation, which excludes volatile energy and food costs, stood at 2.2 percent in the 12 months ended in August.

The loonie, so-called because of the bird engraved on the one-dollar coin, will remain above parity with the U.S. dollar due to an expected further cut in the U.S. Federal Reserve's benchmark interest rate in the final quarter of 2007, RBC forecast.

But it sees the currency depreciating again to below par in the second quarter of next year.