The Canadian Press

The Bank of Canada is keeping rates at historic lows, but it has renewed its warning about the negative impact of a soaring loonie.

The soaring loonie is undermining Canada’s economic recovery to such an extent that it is more than offsetting the more favourable developments the Bank of Canada had seen since July.

The dire warning Tuesday came as the central bank announced it is keeping its key policy rate at the virtual floor of 0.25% and offered no hint it is about to move off the historic low any time soon.

If anything, the tone of the announcement suggests the loonie effect could keep the bank at the lower bound, as it calls it, beyond the end of the second quarter 2010.

“A recovery in economic activity is underway in Canada,” the bank said in a release Tuesday morning, listing a string of developments that have gone right since the recession which likely ended in June.

“However, heightened volatility and persistent strength in the Canadian dollar are working to slow growth and subdue inflation pressures,” it added. “The current strength in the dollar is expected, over time, to more than fully offset the favourable developments since July.”

The bank said Tuesday it is also keeping open its emergency liquidity instruments to ensure credit markets continue to function.

The Bank of Canada has made an unusual commitment to keep its key rates unchanged until the middle of next year but economists have speculated that might change if the economy grew too quickly and inflation threatened to get out of hand.

In September, the last time the bank pronounced on interest rates, governor Mark Carney and the governing council had enthused that the recovery was going so well it was expecting to revise its July growth forecast that predicted 1.3% growth in the gross domestic product in the third quarter and three% in the fourth.

But that was when the bank expected the loonie to average US87¢ through 2010.

It hasn’t been behaving as the bank thought. The loonie is now about US10¢ above the value used in the bank’s projection, making Canadian-produced goods less competitive in the U.S. market.

On Monday, the loonie gained 0.83 cents to close at US97.15¢ and many analysts expect the currency to hit parity with the U.S. greenback as early as next month.

The bank now estimates the economy will shrink slightly more than it had expected in July — not less as it said last month — declining by one-tenth of a point to 2.4%. And growth, while the same in 2010 at 3%, will be more muted in 2011 by two-tenths of a point to 3.3%.

“This is a somewhat more modest recovery in Canada than the average of previous economic cycles,” the bank said.

Although the bank does not make a direct threat to intervene in the currency markets, Tuesday’s more gloomy tone could have the impact of dampening speculation on the currency.

Analysts believe the loonie’s recent rise of about six% for the month is partly due to expectations the Bank could raise interest sooner than next summer over fears low rates was creating an artificial housing bubble in Canada and setting the stage for higher inflation. Australia was the first developed country to raise rates in early August, citing rising home prices.

But the bank’s new warning implies that not only will it likely keep its policy rate at the lower bound beyond its conditional commitment of end of second quarter 2010, it may keep it there longer.

The strong dollar is not only dousing inflation, it is also undermining economic activity in the export sector, particularly Ontario’s manufacturing base.

A strong currency erodes Canada’s ability to export what it makes by making Canadian products less competitive in foreign markets.