The Bank of Canada raised its key interest rate on Tuesday, the first G7 industrialized economy to do so after the global recession, but said the European debt crisis made its next move highly unpredictable.
The rate hike, to 0.5 percent from 0.25 percent, is a response to two quarters of extraordinarily strong growth at home. But the bank cautioned investors against betting on an uninterrupted tightening campaign, due to the euro zone fiscal problems and an uneven global recovery.
Given the considerable uncertainty surrounding the outlook, any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments, the central bank said in a statement.
The rate hike itself was widely expected. In a Reuters poll of 40 analysts, 32 had forecast a quarter-point rate hike.
No surprise in the decision but the tone was slightly more dovish than we or the markets had anticipated, said Millan Mulraine, economics strategist at TD Securities.
Of course we continue to mention our bias for them to raise rates at the next few meetings ... It certainly suggests to us that the bank is not positioning for 50 basis point increases, at least not in the near term, as the market at some point may have priced in, he said.
The lack of a clear message on further rate hikes caused the Canadian dollar to ease after the news to as low as C$1.0556 to the U.S. dollar, or 94.70 U.S. cents, from C$1.0498, or 95.26 earlier in the day. It later recovered to C$1.0490 to the greenback.
Yields on overnight index swaps, which trade based on expectations for the central bank's key policy rate, suggest there is a 67.7 percent chance of a 25 basis point hike at the next announcement on July 20.
I think they did the right thing for a central bank and, given current market and global economic uncertainty, you don't want to show your full hand under these circumstances, said Derek Holt, an economist at Scotia Capital.
But my own personal belief is we still have the need for a made-in-Canada set of monetary policy conditions and that justifies continued hikes, he said.
Several major commercial banks raised their prime lending rates on Tuesday to 2.50 percent, including Toronto-Dominion Bank, Royal Bank of Canada and Bank of Montreal.
All but one of Canada's 12 primary securities dealers, surveyed by Reuters on Tuesday, forecast the central bank would raise rates again on July 20. The same number predicted further hikes in September and October.
The Bank of Canada has broken ranks with the U.S. Federal Reserve in the past, but generally the two policy rates move in tandem. But the U.S. Federal Reserve continues to promise to hold its rate ultra low for an extended period, depending on economic conditions.
The European Central Bank, which has cut rates to 1.0 percent, is far from considering its exit strategy as it takes extraordinary steps to ease the debt crisis and prevent it from snuffing out a recovery on the continent.
Canada's profile of a commodities exporter is closer to that of Australia, which held rates steady on Tuesday but had already lifted borrowing costs six times in eight months.
Canada's economy fell into mild recession last year, but its banks emerged unscathed from the credit crisis and jobless rates did not soar as high as in the United States.
Consumer spending and a hot housing market have fueled a faster than expected recovery since then. The economy grew at a surprising 6.1 percent annual clip in the first quarter, and by 4.9 percent in the fourth quarter of 2009.
The bank said economic activity was broadly in line with its expectations, and inflation was also matching expectations. The new rate is still highly stimulative, it said.
It said the global recovery is increasingly uneven, with emerging markets taking the lead while there is a possibility of renewed weakness in Europe.
The debt crisis in Greece and some other European countries has so far had only a limited impact on Canada through lower commodity prices and tighter financing conditions.
But some countries will now have to cut spending quickly and that, combined with debt reduction by banks and households, could slow global growth.
That could hurt Canada's export-dependent economy.
Recent tensions in Europe are likely to result in higher borrowing costs and more rapid tightening of fiscal policy in some countries -- an important downside risk identified in the April Monetary Policy Report, it said.
The central bank also said it will gradually reduce the amount left in its overnight settlement system for banks to the pre-crisis norm of C$25 million from C$3 billion.
It said it would make its standing purchase and resale agreement facility with primary dealers a permanent part of its monetary policy framework. The facility was introduced in April 2009 to help the bank manage the overnight market at record low rates.
(Additional reporting by Ka Yan Ng, Claire Sibonney and Euan Rocha; editing by Janet Guttsman and Rob Wilson)