Source: The Canadian Press

The Bank of Canada reversed course on its monetary policy Tuesday, keeping its benchmark interest rate at 1% in the face of a weakening economy.

The bank had increased short-term interest rates three consecutive occasions since June, but said Tuesday that was enough as it scaled back growth projections for the economy.

And the bank’s bleak new outlook for growth — about half a percentage point lower for this year and next than it projected in July — likely means it will stay on the sidelines for some time, economists said.

The reduced expectations, combined with China raising interest rates to slow down its torrid economy, sent the loonie tumbling almost two cents US.

In an unusually detailed and dour communique accompanying the rate announcement, the central bank’s governing council said it now expects the slow recovery from recession to be so protracted that it won’t be until 2012 before the economy returns to full capacity, a full year later than previously thought.

“The economic outlook for Canada has changed,” the bank’s senior officials wrote.

“At this time of transition in the global recovery, with a weaker U.S. outlook, constraints beginning to moderate growth in emerging-market economies and domestic considerations that are expected to slow consumption and housing activity in Canada, any further reduction in monetary policy stimulus would need to be carefully considered.”

TD Bank chief economist Craig Alexander said markets had been expecting the benchmark interest rate to hold at 1%, but not the central bank’s negative statement.

“I think the market is surprised by the extent of revisions in economic growth and the very sombre tone,” he said.

“I don’t think the bank of Canada is going to pause for only one meeting. I think the most likely scenario now is the Bank of Canada is going to be on the sidelines for at least until next March.”

Bank governor Mark Carney will want to see how much quantitative easing the U.S. will undertake, and how the U.S. economy fares, before resuming its tightening cycle, Alexander said.

Some economists say it could even be longer, and Brian Bethune of IHS Global Insight said the policy reversal raises questions about whether Carney jumped the gun over the summer in becoming the only G7 central banker to start removing monetary stimulus.

He noted that long term rates were falling, reflecting the weak economy, while Carney was raising short-term interest rates.

“It was an odd cocktail of policy,” he said. “The problem with that is that encourages hot money flows into Canada and pushed up the Canadian dollar, and all that does is hurt small business.”

In the revised forecast, the bank said Tuesday it now believes Canada’s economy will likely grow about 3% this year instead of the 3.5% it had predicted in July — and that’s all due to a faster-than-expected start to the year.

Next year will be even worse, with moderate growth of 2.3%, six-tenths of a point lower than previously projected.

It’s not until 2012 that the bank sees the economy gathering steam, but at 2.6%, that’s still far below Canada’s historic growth levels during expansionary periods.

More surprising was how far the bank’s senior officers set back the time frame for the economy to return to normal, or full-capacity — to the end of 2012 from the previously thought end of 2011.

“This more modest growth profile reflects a more gradual global recovery and a more subdued profile for household spending,” they wrote.

The bank said with household debt so high, it expects Canadians will spend less on consumer goods and on homes, meaning the housing market is in for a protracted cooling-off period.

Given that Ottawa is phasing out fiscal stimulus in March and consumers don’t have the means to keep spending, the Canadian economy will need to depend on exports and business investments, two sectors that have been extremely weak over the past few years.

It warned that exports will be sensitive to currency movements, a reference to efforts by the U.S. to devalue their dollar and corresponding strength of the loonie.

For the rest of the world, the coming fight over currency exchange rates — largely between China and the U.S. — and unresolved global imbalances will result in a more “protracted and difficult recovery,” the bank said.

Currency manipulation has emerged as the most contentious issue at the upcoming G20 finance ministers meeting later this week and leaders summit in November, both in Korea, with the potential to split the group between advanced and emerging nations.

The U.S. recovery will be particularly weak, it noted, with the corresponding drag on Canadian exports south of the border.

Even growth rates in emerging economies are expected to ease, the bank wrote, as fiscal and monetary policies are tightened.

As for prices, the bank’s key focus, its best guess is that both total and underlying inflation won’t reach the bank’s 2% target until the end of 2012.