By Cameron French
KINGSTON, Ontario (Reuters) - Canada will need to raise interest rates to prevent the build-up of inflation in an economy that is growing faster than was expected just one month ago, a senior central bank official said on Monday.
The remarks, tied to a forecast of strong growth and relatively muted inflation, suggest the bank will lift rates at its next announcement date on Sept. 8. That would shift Canada to a tightening cycle after three rate cuts earlier in the year.
The economy is now expected to have grown at an annualized rate of 5 percent in the second quarter, above the bank's previous forecast of 4 percent, Bank of Canada Deputy Governor David Longworth told the Canadian Association for Business Economics in Kingston, Ontario.
He said data received since July showed the economy was operating at a "somewhat higher level" and the output gap -- the difference between what the economy produces and what it is capable of producing -- was smaller at mid-year than the bank had previously thought.
"With the output gap in Canada closing, we will need to reduce the amount of monetary stimulus in the economy to avoid a build-up of inflationary pressures," Longworth said.
"But the timing and magnitude of interest rate increases will depend on how the prospects for inflation and pressures on capacity evolve."
Canada's overnight rate stands at 2 percent.
Longworth said higher oil prices meant overall inflation would be "somewhat higher" for the rest of this year than the bank had assumed in its July Monetary Policy Report update.
He also noted that the stronger energy prices could mean slightly lower growth in the United States and abroad, although he said the bank had not fundamentally changed its external outlook.
But core inflation, which strips out volatile food and energy prices, would remain just above 1.5 percent for the rest of 2004 due to excess supply in the economy.
The central bank sets monetary policy with the aim of keeping inflation at the midpoint of a 1-3 percent range, watching both the overall rate and the less volatile core rate.
Longworth also said that the Canadian dollar's rally over the past year had put some downward pressure on prices.
The central banker's upbeat comments come in the wake of economic numbers that have pointed to a resilient economy. The trade surplus hit a record in June while factory shipments also soared.
The strong trade data comes as the Canadian dollar flirts with the decade-highs that it last touched in January.
The currency's 20-percent rise last year was seen as having a dampening effect on the economy, as it raised the price of, and lowered demand for, Canadian exports.
Answering questions after the speech, Longworth acknowledged the resilience of the export sector in the face of the strong currency, but said there still could be some ill effects to come.
"The lags here, in terms of the volume of exports responding to the exchange rate, would be expected to be at least three years," he said.
"It's by no means over, but so far, so good. Part of the downside risk has disappeared."
The remarks should bolster expectations among Canadian primary dealers, most of whom are already forecasting a rate hike of 25 basis points in September.
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