With Canadian economic growth revving up and the U.S. economy firing on all cylinders, look for the central banks of both countries to rebalance monetary policy soon, says a report by TD Bank Financial Group, which predicts a Bank of Canada overnight rate of 4.25% by the end of 2005.

In its most recent quarterly economic forecast, released Thursday, the bank says that the U.S. Federal reserve Board will be the first to raise rates, but the Bank of Canada will not be far behind.

The Fed is poised to start its tightening cycle with a quarter point hike on June 30.

The report by senior economist Craig Alexander says that with the U.S. economy on track to grow by just shy of 5% this year, and with Canadian economic growth expected to rise at more than a 3% pace in the coming quarters, the slack in both economies is being rapidly used up.

“Remembering that monetary policy works with a lag, the Bank will need to think about raising rates fairly soon, with a view to restoring monetary policy to something significantly closer to a neutral setting – which we estimate as an overnight rate of 4.75%, says Alexander.

“However, like the Fed, the Bank may not take rates all the way to a neutral stance in 2005, as it may be uncertain as to precisely how much slack has been exhausted. Our forecast is for the central bank to begin raising rates in September, although the recent economic data suggest it would be completely justified in pulling the trigger at the next fixed announcement date on July 20th.”

Alexander says the bank’s forecast is that the overnight rate will rise from 2% to 2.75% by the end of this year and will reach 4.25% by December 2005. That would take the prime lending rate, the benchmark for consumer and business borrowing at commercial banks, from 3.75% now to 6%.

Alexander acknowledged concerns that rate hikes pose a threat to the economic expansions in the U.S. and Canada, and, correspondingly, that they might destabilize financial markets. “But, we believe that both economies are sufficiently resilient to cope with a reduction in monetary stimulus,” he said.

The report notes that the impact on consumer finances will be partially offset by income growth and employment creation. Housing markets will be constrained by higher interest rates, but the current level of activity and the recent pace of price increases have been unsustainable, so some cooling is desirable.

As for financial markets have been fretting about the impact of higher rates, Alexander argues the level of rates is more important than the direction. “The low current starting point means that corporate profits will not be significantly crimped by the rate hikes we anticipate this year, implying that earnings will continue to rise. Nevertheless, the pace of growth of corporate profits will slow in 2005, as rates get closer to neutral levels.”

Bonds will also be negatively affected by central bank rate hikes, Alexander says. However, much of the adjustment has already occurred, particularly for longer-dated instruments, where yields have backed up by more than 100 basis points from their recent lows.

“Accordingly, with inflation to remain subdued and central bank rates to remain below neutral, bond yields are expected to rise further only gradually. Short-term rates will increase faster than long-term rates, which implies a flattening of the yield curve.

“But, it is important to stress that both the current level of rates and the steepness of the yield curve are not normal – investors have just become used to them because monetary policy has been so stimulative for such a long time. “