As expected, The Bank of Canada today announced that it is maintaining its target for the overnight rate at 3%.

The operating band for the overnight rate is unchanged, and the Bank Rate remains at 3 1/4%.

In its accompanying statement, the bank said it expects economic growth in Canada this year of only one%. Growth is expected to rise to 2.3% in 2009 and 3.3% in 2010.

The bank also issued a warning over its outlook for inflation.

“Assuming energy prices follow current futures prices over the projection period, total [Consumer Price Index] inflation is projected to rise temporarily above 4, peaking in the first quarter of 2009,” the bank said.

Canadian economists say the Bank of Canada is likely to keep interest rates in holding pattern until mid 2009, given the uncertain economic outlook.

“The statement indicated that surprises since the April Monetary Policy Report have been largely on the side of inflation with the CPI now expected to move above, albeit temporarily, 4%. On the growth side developments have largely been in line with their views expressed in April,” noted RBC Capital Markets. It adds that there seems to be little concern about the recent deterioration in financial markets with the bank even indicating that they expect growth to move above potential by “early next year.”

The Bank of Canada’s statement focused on three main areas, RBC observed: protracted weakness in the U.S. economy; ongoing turbulence in global financial markets; and sharp increases in many commodity prices. “While the statement indicated that the first two factors are evolving in line with the Bank’s forecasts, the unprecedented rise in commodity prices has raised the upside risks to inflation while keeping Canada’s terms of trade improvement intact and supporting income growth,” it said.

The Bank of Canada downgraded forecasts for growth in 2008 to 1% from 1.4% but was optimistic that the combination of accommodative monetary policy, the terms of trade boost and a “gradual “ recovery in the U.S. economy will see Canada’s growth rate rise to above-potential early next year, RBC added. Also, 2009’s growth forecast was reduced modestly to 2.3% from 2.4%; with the economy expected to grow 3.3% in 2010.

“More importantly, the Bank upped their forecasts for headline inflation and said that the rate will remain higher for longer than in the April forecast,” RBC said. While the Bank now says that headline inflation rate may “rise temporarily above 4%, peaking in the first quarter of 2009”; it also believes that core inflation “is projected to remain well contained and broadly in line with earlier expectations, averaging close to 1.5% through the third quarter of this year and then rising to 2% in the second half of 2009.” The forecast for the second half of 2009 was revised up from April’s 1.8%.

RBC said that the biggest surprise is that the Bank of Canada has raised the prospect that the headline inflation rate could rise to 4% in the near term and will remain above target into next year. “Despite the somewhat hotter inflation environment, forecasts that the economy will grow at a slower than potential rate this year (and we think that downside risks to the economy mounting given renewed financial market turbulence), suggests that the Bank is likely to hold the policy rate at 3%,” it concluded.

National Bank Financial observed that the Bank of Canada “is currently navigating in waters where crosscurrents are very strong.” As a result, it believes the decision to stand pat was sensible. “Our base case scenario suggests that U.S. economy will still be sluggish in 2009 and Canada will be growing by 1.9%, compared to the Bank’s 2.3 % projection. Consequently, we continue to believe that we will be well into 2009 before the Bank will be in a position to raise rates,” NBF said.

“While the Bank has ramped up the inflation forecast, the reality of the global credit crunch and dicey outlook for the U.S. economy will keep them on hold for some time yet,” agrees BMO Capital Markets. “We have been calling for the Bank to stay on hold until the spring of 2009, when we see them starting to bump rates higher, and there is nothing here to change that view.”

Monetary Policy Report Update to be released later this week

@page_break@The central bank’s detailed projection for the economy and inflation, and its assessment of risks to the projection, will be published in the Monetary Policy Report Update on July 17.

The Bank of Canada’s next scheduled date for announcing the overnight rate target is September 3.