Bank of Canada holds its benchmark interest rate at 1%, says interest rate cut is still a possibility despite bank's forecast of accelerating inflation this year

Cindy Allen

OTTAWA , April 16, 2014 (Thomson Reuters Corp.) – * Rates on hold at 1 percent since September 2010

* Bank flags "downside risks" of weak inflation

* Sees "elevated" risk of household imbalances

* Signals it will focus on core rate inflation in 2014

* Cuts Q1 GDP growth forecast; outlook for year unchanged (Recasts with comments from Governor Poloz at press conference)

Canadian central bank chief Stephen Poloz said on Wednesday an interest rate cut is still a possibility even though the bank forecasts inflation will pick up speed this year and approach its 2 percent target.

The Bank of Canada held its benchmark interest rate at 1 percent, as expected, extending a 3-1/2 year freeze on borrowing costs.

Poloz described the bank's monetary policy stance as neutral, as it has been since last October, meaning there is just as much chance of a rate cut as of a hike.

Following the release of some stronger economic data recently, market players had been watching for any sign he would change his tone on inflation to be less dovish than he was in the bank's March and January rate statements.

But in its Wednesday statement, the bank repeated that "the downside risks to inflation remain important", although there are also risks associated with near record-high household debt.

"We are neutral. And that means that rate cuts cannot be taken off the table at this stage," Poloz told reporters.

"I would remind you that inflation today is almost exactly what is was in January, when we last put out an MPR (Monetary Policy Report)."

The bank said the timing and direction of its next rate move will depend on data.

In a Reuters poll published on April 9, economists predicted the bank would not make a move on rates until the third quarter of 2015, when they forecast it would opt for 25 basis point rise.

"There is still a remote chance ... maybe 20 or 30 percent at most, that a rate cut scenario could be in the cards, but I think that is unlikely," said Derek Holt, economist at Scotiabank.

Traders have been pricing in a very small chance of a rate cut later this year and they slimmed down that bet further after the bank's Wednesday press conference and quarterly Monetary Policy Report.

VIEW ON 'LOWFLATION'

The biggest change in the bank's forecasts came in the Monetary Policy Report, with the bank saying it sees a faster than expected rise in Canada's headline inflation rate, which has been below its 2 percent target for nearly two years.

The bank now sees the rate hitting 2 percent in the first quarter of 2015 and staying there through 2016. In January, the bank forecast it would not reach 2 percent until the fourth quarter of next year.

However, the bank suggested it would not react to the increase in that inflation measure because it will mainly reflect temporary upward pressure from higher gasoline and natural gas prices and a weaker Canadian dollar.

Core inflation, which strips out volatile items, is seen taking longer to regain momentum due to excess slack in the economy and intense retail competition. The bank's projections for core inflation are largely unchanged from January and show a return to 2 percent in the first quarter of 2016.

Total inflation will stay at about 2 percent, it said. That's because as the effect of higher fuel prices fades, the downward pressure from retail competition is expected to persist for another 1-1/2 years and excess capacity will be absorbed.

Still, most economists said Poloz seemed a little less worried about disinflation than he was a few weeks ago.

"Somehow, the bank managed to find a way to sound even more concerned about 'lowflation' even as they upgraded the forecast for headline inflation," said Doug Porter, chief economist at BMO Capital Markets.

"They can't ignore headline inflation if energy and food prices start to run wild. They can't turn a blind eye to that, but they would largely focus on the core inflation outlook."

The bank said it expected the drivers of growth and inflation in Canada to gradually strengthen as the United States recovers from a weather-related slowdown. But its outlooks for exports and business investment remain weaker than in its January forecasts.

It cut its forecast for Canadian economic growth in this year's first quarter to 1.5 percent from 2.5 percent, annualized, and predicted growth of 2.3 percent and 2.5 percent in 2014 and 2015, respectively.

It raised its inflation forecast for the first quarter to 1.3 percent from 0.9 percent. (Editing by Randall Palmer; and Peter Galloway)

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