RBC Economics predicts that the Bank of Canada will start raising rates in late 2007, but that the U.S. central bank won’t have to start hiking until the second quarter of 2008.

“Canada’s economy is picking up pace with first quarter GDP growth on track to meet our 2.8% (annual rate) forecast,” it says. “Tight labour market conditions/growing incomes are supporting consumer spending and business spending remains firm. The rise in the Canadian dollar may dampen export demand but will be limited by a strong appetite for commodities and robust import demand. We expect Canada’s economy to grow by 2.5% in 2007 and an even faster 3% in 2008 – this is not new.

“What is new is that Canada’s inflation rates increased at a faster pace than policymakers expected in the first quarter and these indices will remain elevated over the next few quarters,” it says. “While the bank may tolerate higher inflation in the near-term, a persistent run above the target is likely to lead policy-makers to view policy as inconsistent with reaching their medium-term inflation goals. Also, we expect that the surprises to the bank’s growth outlook will prove to be to the upside meaning that the economy will remain in excess demand rather than back to its productive capacity as the bank expects.”

RBC is now looking for the bank to raise the overnight rate by 25 basis points to 4.5% in December 2007 with additional 25 bps moves expected in each of the next three quarters. This means that the overnight rate will peak at 5.25% in the middle of 2008. “Interest rates will remain range-bound over the next quarter as investors assess the true momentum of the economy but then start to rise with the 10-year rate increasing to 4.75% at yearend 2007 and 5.35% bps at year-end 2008,” it concludes.

Meanwhile, in the U.S., RBC has taken a predicted June rate cut out of its forecast for the Federal Reserve Board, despite the fact that futures markets now see a single rate cut as the most likely outcome this year. “Mixed data have supported two main themes in our view — the U.S. consumer is not yet flagging and the business sector is not headed for a sustained downward turn,” it says. “While the first print on Q1 GDP was disappointing, the consumer proved unexpectedly resilient and the business spending got a bit of a lift.

“Employment gains have also beat market expectations and wage growth remains robust lending support to the consumer despite the negative impact from the housing market correction. We see little reason to deviate from our forecast that the US economy will reaccelerate as we head into the second half of the year,” RBC notes.

“For the Fed, the primary concern about the outlook remains inflation and the current environment gives them little wiggle room to push rates down. Furthermore the global economy is growing strongly and inflation pressures are emanating from many regions,” it adds.

“We now expect the Fed to raise the Funds rate by 25 bps in the second quarter of 2008 and again in the third quarter with the rate peaking at 5.75%. Interest rates have likely seen the bottom and although the risks to both the growth and inflation profiles will keep 10-years trading in a range between 4.60% and 4.85% in the near-term, the yield is likely to rise to 5.25% by year end as growth momentum picks up,” it concludes. “In 2008, we expect long-term interest rates to continue to move higher with the 10-year yield rising to 5.75% by year-end.”