Economists at TD Bank say that the strength in the Canadian dollar will likely help limit Bank of Canada rate hikes.

In a research note, TD says that the Bank of Canada’s Monetary Policy Report, released today, highlighted how the Bank of Canada had underestimated recent economic activity, both in Canada and abroad, as estimates on both fronts were revised up.

“Given that first quarter Canadian real GDP growth of 3.7% had dramatically exceeded the Bank’s estimate of 2.5%, and that it now believes the second quarter will come in half a percentage point stronger at 2.8%, the Bank had little choice but to nudge up the 2007 economic growth estimate to 2.5% from 2.2%,” it said. “However, as noted in Tuesday’s communiqué, there were complementary downward revisions to the 2008 and 2009 outlook from 2.7% to 2.5%. All of these revisions now place the Bank’s GDP estimates in perfect alignment with our own forecast.”

TD also notes that the central bank, “has consistently underestimated the stickiness of core inflation since the start of the year”, adding that it now believes core inflation will remain above the target until early 2009.

“The combination of stronger economic growth and elevated inflation largely explains the quarter-point hike in interest rates on Tuesday, with the likelihood of another in September,” TD suggests.

That said, TD adds that, “The strength in the Canadian dollar should not only help reign in inflation by restraining economic growth and import prices, but we feel it will also limit the degree to which the Bank needs to hike rates.”

In a separate note, TD stresses that the dollar will likely be a very influential factor in future policy moves, adding that the Bank downgrading its 2008 and 2009 growth forecasts comes in response to the currency’s gains. “What the Bank has not told us is what interest-rate assumptions are embodied in that outlook. But given the very modest slowdown the Bank is looking at, and given the impact of the stronger currency, it does not look like Mr. Dodge is thinking big on the rate front,” it says.

“Granted, the Bank could be wrong in its views. The most significant risk – and one that suggests that the odds of more hikes is higher than the odds that the Bank will move less — is that the Bank could still be overestimating the economy’s long-run cruising speed, because of weak productivity growth. If that’s the case, inflation pressures could continue to bubble up, even if the economy matches the Bank’s growth expectations. And, that could mean more rate hikes down the road. But as far as the near term goes, keep your eyes locked on the Canadian dollar,” TD concludes.