The Bank of Canada is carefully watching “the marked volatility and sharp appreciation of the Canadian dollar” but remains wary of inflation, Pierre Duguay, deputy governor of the central bank, said today.

In a prepared speech delivered to CFA Québec in Quebec City, Duguay said that “the Canadian economy is operating above its production capacity and the momentum in domestic demand has been strong in spite of the tightening of credit conditions that has occurred in the wake of recent financial market turbulence.”

Duguay offered no indication the bank will reduce interest rates in its next scheduled policy announcement December 4.

But he noted the recent disorder in debt markets, provoked by the collapse of the American high-risk mortgage sector.

And he acknowledged that this could affect the interest rate policy of the Bank of Canada and other central banks, observing that “a reassessment of default risk that increases risk premiums and results in tighter credit conditions may require a lower policy rate than would have otherwise been the case.”

However, the financial system “has thus far weathered the turbulence reasonably well,” he said.

In his conclusion Duguay said “it appears that Canadian companies and Canadian banks are in a strong position to withstand the turmoil.”