Canada’s economy, while feeling the impact of world uncertainties, is showing sustained strength, says David Dodge, Governor of the Bank of Canada in a Speakers Forum address in Toronto. To stay that way, the bank will likely need to raise interest rates in the coming year.

Good luck and good policy are the reasons Canada’s economy is operating close to capacity, says Dodge, citing emerging production constraints, a shortage of skilled labour in some sectors, and higher profit margins in the first three quarters of 2002.

“All of this suggests that most goods prices in Canada are not being discounted because of weak demand, as appears to be the case in the United States.”

On the investment side, he adds, “Canadian corporate balance sheets are improving and are, indeed, in relatively good shape compared with those in other countries.”

He says efforts to adjust to free trade and curb inflation in the 1990s, though painful, are “now yielding clear economic dividends.” He went on to say that the bank remains committed to policy with an aim to keep the trend of consumer price inflation at or around 2%.

In recent months inflation has risen substantially as a result of higher oil and gas prices, higher home and auto premiums, higher tobacco taxes, and in Ontario, higher electricity prices. He also cites an “echo effect” of temporary price discounting in late 2001 following September 11.

Although he says the bank doesn’t have a crystal ball to determine the outlook for geopolitical events, the time spent examining the factors such as those driving electricity prices, insurance and some foods are considered in order to keep a handle on inflationary concerns.

When it comes to deflationary concerns he says the goal of the bank’s policy is to avoid situations such as declining profits and share values, increased debt burdens, business bankruptcies, lower investment and a further weakening of demand. “It is precisely for this reason that Canada’s inflation targeting framework operates symmetrically,” he says. The bank also monitors credit and financial market developments to gauge the climate for business investment.

“While Canada’s economy has outperformed those of major trading partners, our prospects are still very much influenced by developments abroad.” Those developments, most notably in the Middle East “remain the great uncertainty,” says Dodge.

He says a negotiated resolution or a short, decisive conflict could reduce tensions, but warns “a prolonged war would make the world economic outlook even more uncertain and would hurt business and consumer confidence.” Higher oil prices and further restraint on global economic activity are two possible outcomes.

Based on the assumption that related uncertainties dissipate in the second half of 2003, the bank anticipates increased demand, and easing core inflation by the second half of 2003, into 2004.

Although he says the recent boost in inflation was as a result of “special factors,” he says “we can’t rule out the possibility that demand pressures are becoming more prominent.” To achieve the target 2% and guard against inflation expectations, interest rates will likely rise. “