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Economic Insight Poloz likely to hold rates steady this week as he waits for economic fog to lift

The Bank of Canada looks set to stand pat on interest rates in its latest policy announcement this week, as it waits for the fog to clear on what has been a murky first few months of 2015.

The consensus of economists, as well as financial markets, is that Canada's central bank is all but certain to maintain its key interest rate at 0.75 per cent when it announces its latest policy decision Wednesday morning. (The bond market is pricing in just a 6-per-cent chance of a rate cut.) The rate has been at that level since January, when Bank of Canada Governor Stephen Poloz stunned the markets with a quarter-percentage-point rate cut, which he described as "insurance" against the downside risks to Canada's economy from the sharp fall in oil prices.

The central bank is also highly unlikely to revise its formal forecasts for the Canadian economy, which call for growth to pick up after a stagnant first quarter. As a matter of course, it only updates those forecasts in its quarterly Monetary Policy Reports, the next of which isn't due out until mid-July. Nevertheless, the financial markets will sift through the statement accompanying the rate decision with a fine-toothed comb, looking for any shifts in the bank's views on the state of the economy and its prospects for the coming months.

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In a speech in Charlottetown last Tuesday – the last before the central bank entered its pre-rate-decision "blackout" period for public communications – Mr. Poloz delivered remarkably little new of substance about the bank's views on the economy, disappointing many observers. But his speech suggested that Mr. Poloz hasn't yet seen anything to shake his optimism that the Canadian economy will rebound in the second quarter and be much stronger in the second half of the year, as the oil shock's impact fades and exports pick up steam – keeping on track the bank's forecast of a return to full capacity by the end of 2016.

The implication, then, is that the bank has no need to change its key rate.

But in a press conference following his speech, Mr. Poloz suggested that his stand-pat view is due at least in part to a lack of clarity on the underlying state of the economy – particularly in the crucial U.S. export market, where growth has been disappointing in the first few months of this year. Most experts believe that the U.S. recovery was merely temporarily delayed by an unusually harsh winter and by West Coast port strikes. But persistently weak retail sales have been disquieting, as the anticipated consumer spending boost stemming from cheap fuel prices hasn't materialized – at least not yet.

"The U.S. economy is slightly puzzling right now," Mr. Poloz said. "That's why I'm not offering you a new forecast today."

"It looks like it's steady as she goes for Poloz and the Bank of Canada, as they wait to see more Canadian data before changing tack," Benjamin Reitzes, senior economist at BMO Nesbitt Burns, said in a research note.

One piece of the data puzzle that fell into place during the Bank of Canada's deliberations over the past week was inflation – the most critical factor in the central bank's rate decisions, as its policy is rooted in maintaining its inflation target of 2 per cent. On Friday, Canada's consumer price index inflation rate came in at a thin 0.8 per cent, owing to sharply lower energy prices compared with a year earlier. But, the "core" inflation rate – which excludes energy and other highly volatile components of CPI, and is closely watched by the central bank as a guide to underlying inflation pressures – was 2.2 per cent, its ninth straight month above the bank's 2-per-cent target. Still, Mr. Poloz has said that even the core measure is being skewed up by temporary factors, and true underlying inflation looks closer to a below-target 1.6 to 1.8 per cent, reflecting continued excess capacity in the Canadian economy.

One key piece of information that we won't have in hand when the central bank makes its rate announcement, though, is Canada's first-quarter gross domestic product; Statistics Canada is scheduled to publish those data next Friday, two days after the Bank of Canada decision. The bank said in its most recent Monetary Policy Report, in mid-April, that it believes GDP had zero growth in the first quarter, but it expects a rebound to an annualized rate of 1.8 per cent in the second quarter.

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The flow of economic data since then has been consistent with tepid growth in the quarter, though private-sector economists are generally optimistic that growth was a bit better than zero. The average forecast of economists surveyed by Bloomberg is for an annualized growth rate of about 0.5 per cent in the quarter.

Mr. Poloz believes his surprise rate cut in January has provided a timely stoking of the country's economic fires. He stressed in his Charlottetown speech that the easing borrowing conditions that followed would have provided savings for borrowers, while the weakening of the Canadian dollar after the rate cut would deliver an estimated $20-billion over the year to Canadian companies with existing export contracts priced in U.S. dollars, based on a 3-cent (U.S.) drop in the exchange rate.

But economists noted that the impact of the rate cut on market interest rates and the currency has already considerably faded. The yield on the benchmark Canadian government 10-year bond is now actually higher than it was before the rate cut, and the loonie has regained most of what it lost, driven by a rebound in oil prices.

"That means financial conditions are more restrictive, leaning against the expected acceleration in Canada's economy in the second half of the year," said Toronto-Dominion Bank economist Leslie Preston.

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