* 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 (Reuters) - 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 Bank.
“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”. [ID:nN1E75N0M2]
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. BOCWATCH
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)