The Bank of Canada expects the economy grow modestly in the second quarter of 2008, rebounding from a contraction in the first quarter.

In the update to its monetary policy report released today, the central bank projects annualized second-quarter growth of 0.8%, a turnaround from the -0.3% annualized contraction seen in the January-March period.

The bank’s latest outlook for the April-June quarter was slightly better than the 0.3% growth rate it projected back in April.

The bank said it also sees full-year growth of 1% for 2008, 2.3% in 2009, and 3.3% in 2010.

“Excess supply in the Canadian economy is projected to increase further through late 2008, but to gradually dissipate with the acceleration in aggregate demand,” the central bank said in a release. “The economy is thus projected to return to balance around mid- 2010.”

The bank also said higher energy prices will push total Consumer Price Index inflation temporarily above its upper target range of 3% peaking in the first quarter of 2009, but core inflation — which factors out the more volatile influences — will remain contained.

Assuming energy prices follow current futures prices, inflation is projected to rise temporarily above 4%, before retreating back to 2% in the second half of next year as energy prices moderate.

Based on today’s update, Bay Street economists believe that the Bank of Canada will keep interest rates on hold for some time.

BMO Capital Markets says that the central bank doesn’t seem overly concerned about this year’s patch of weak growth. “They see GDP picking up to 1.5% in the second half, and see 2.3% growth next year. The Bank highlights the strength in real incomes, and extols the benefits of stronger terms of trade,” it says.

It notes that the Bank of Canada also downplayed concerns that inflation expectations are rising. “They still believe inflation expectations are “well-anchored” around 2%. While they have nudged up the core CPI outlook, they still see it below 2% until the second half of 2009,” it says. “Overall, they don’t sound alarmed by the prospect of some scary headline CPI results in the months ahead.”

BMO reports that the central bank was also quite specific in its estimates of the impact of the credit crunch –average borrowing costs have been pushed up by 75 bps because of it, offset by their 150 bps of easing, so overall borrowing costs are down 75 bps. “They are surprised by the resiliency of consumer borrowing trends, and find that the banks have not tightened lending standards on this front. They again noted that Canadian conditions are much healthier than the rest of the world,” it notes.

TD Economics says that the Bank of Candaa emphasized three shocks hitting the Canadian economy all at once: protracted weakness in the U.S. economy, financial market turmoil, and surging commodity prices. “The Bank views the first two as unfolding largely in line with its April MPR forecast. It is commodity prices that have caught them off-guard, and admittedly most others, including ourselves,” TD notes.

“The main upside risks to this outlook are that oil prices could keep trekking upwards unabated and/or that firms pass on their input cost inflation to final goods to a greater extent. As for downside risks, we remain more pessimistic than the Bank on the U.S. growth outlook for 2009, which results in both U.S. and Canadian real GDP growth forecasts that are a half-percentage point lower than theirs,” it says.

“The likelihood remains high that growth could disappoint while energy prices or their trickle-down to final goods prices will be higher yet. If these risks were to materialize and ‘stagflation-lite’ turn into outright stagflation, the Bank would send a shot across the bow (tweaking rates upwards) as a reminder it has not lost sight of its mandate. We’re not there yet, and our most likely scenario has the BoC on the sidelines until the second half of 2009,” TD concludes.

“While the Bank is relatively upbeat on global growth and the Canadian economic outlook in 2009/10, they are still sounding relatively relaxed about the inflation outlook. That sounds like the Bank is comfortable keeping rates on hold for some time yet,” BMO forecasts.