The Canadian economy is now running near capacity and inflation is expected to head higher Bank of Canada Governor David Dodge told the House of Commons Finance Committee today. Nevertheless, he cautioned that future interest rate hikes will be based on the bank’s evolving views on inflation.

Dodge noted that when he last appeared before this committee last April, the economy was judged to be operating significantly below its potential. “That is no longer the case, because the Canadian economy has grown faster than was projected in last April’s Monetary Policy Report and the July Update. This stronger growth was largely due to a surge in exports,” he said. “The economy is now operating near its production capacity and continues to adjust to global economic developments.”

He reported that the Bank’s forecast through the end of 2006 calls for aggregate demand for Canadian goods and services to expand, on average, at about the same rate as potential output. “Given the effects of higher oil prices and the past appreciation of the Canadian dollar, the Bank projects economic growth to be slightly less than 3% in 2005, and slightly more than 3% in 2006,” he noted.

Dodge reiterated the Bank’s forecast for inflation to hit 2% by the end of 2005, the same projection that it made last April. “However, given the path suggested by futures prices for crude oil, the Bank expects total CPI inflation will rise to the top of the 1% to 3% target range in the first half of 2005, before falling slightly below core inflation in early 2006,” he said.

“The base-case projection assumes further reduction of monetary stimulus over time, to keep the economy near its production potential and to achieve the inflation target,” Dodge said. “I want to emphasize that the pace of interest rate increases will depend on the Bank’s continuing assessment of the prospects for factors that affect pressures on capacity and, hence, inflation.”

He also noted that there are significant risks and uncertainties around this base-case projection, “related to the adjustment to changes in the global economy, including changes in commodity prices and exchange rates. The risks surrounding global economic prospects relate primarily to the evolution of oil prices, the pace of expansion in China, the way in which current account imbalances in the United States and East Asia will be resolved, and geopolitical developments.”