As expected by many economists, the Bank of Canada left its key interest rate unchanged at 1% Tuesday and issued a gloomier economic forecast. The question for investors is how long is the pause likely to last.

TD Economics says that the length of the pause will mostly depend on how the U.S. and Canadian recoveries unfold. The move from hiking to standing pat on rates comes as the recoveries have disappointed. Indeed, TD notes that the BoC cut its July forecasts for GDP growth of 3.5% and 2.9% growth in 2010 and 2011 respectively, to 3.0% and 2.3%; however the forecast for 2012 was upgraded from 2.2% to 2.6%.

The inflation picture is not as much of a factor. “Canadian inflation has been a tad softer than expected in July, but not so much so as to justify an extended pause at a level of the overnight rate which is still negative in real (inflation-adjusted) terms. In others words, softer inflation is not the factor driving the Bank of Canada to the sidelines, nor is stronger inflation likely to be the immediate trigger behind a renewed hiking cycle,” it says.

National Bank Financial says that the BoC’s statement was more dovish than expected, and it notes that the central now projects that the Canadian economy will not return to full capacity until the end of 2012, a full year later than was predicted in the July Monetary Report. Inflation isn’t expected to reach 2% until the end of 2012 either.

“Heightened tension in the currency markets and related risks associated with global imbalances were also pointed out as a potential hazard to the global recovery,” NBF says. “Obviously, without being explicit about it, the Bank on Canada is nervous about what could happen to the Canadian dollar in the context of a resuming of quantitative easing in the U.S.”

Indeed, a second round of quantitative easing in the U.S. is expected later this year. As a result, TD says that it will probably be next March before the BoC will have a read on whether that program is working. “By then, the Bank of Canada will have had time to digest economic data for the second half of this year and will also see how 2011 is starting off,” it says.

RBC Economics also sees the BoC on the sidelines until March 2011. BMO Capital Markets says that it thinks the Bank will be on hold until May of next year.

“In the interim, do not look for the Bank of Canada to hint at how long it may stand pat, for fear of reigniting a surge in credit demand. It will, however, be eager to signal its next hike at the first opportunity provided by strong enough economic data,” TD says. It expects the overnight rate to reach 2.00% by the end of 2011.

IE