BMO predicts that the Bank of Canada to raise rates twice this summer

BMO predicts that the Bank of Canada to raise rates twice this summer

The Bank of Canada will boost interest rates twice this summer, propelling the Canadian dollar to soar to new 30-year highs, the Bank of Montreal (TSX:BMO) predicts.

The BMO Capital Markets report forecasts that despite recent dampening signals, the central bank will tighten monetary policy for the first time in over a year starting with a 25 basis point hike next week, and further turn the screw on Sept. 5.

This will elevate the bank's key lending rate to 4.75 per cent from the current 4.25 per cent, a move that will not only add fuel to the already soaring loonie, but increase the cost of borrowing for both businesses and homebuyers taking out mortgages.

"The loonie would easily fly above 96 cents US," said the report written by economists Michael Gregory and Benjamin Reitzes. "But while a test of parity is possible, we judge that it's not probable."

The Canadian dollar closed up 0.16 of a cent to 94.46 cents US on Wednesday, the highest since early June, 1977.

In recent weeks, many economists have been softening their hard predictions that bank governor David Dodge will raise rates significantly this year.

After warning in May that the Canadian economy was overheated and interest rates stubbornly holding well above the bank's two per cent target, the bank has tempered its comments of late, including suggestions that the loonie's flight may not be justified by the fundamentals.

Recent economic data has also been weaker than expected, including last week's gross domestic product report showing zero growth in April, and core inflation cooling to 2.2 per cent in the same month, from 2.5 per cent in March.

But the BMO economists say May's consumer price index, when it is released in two weeks, will again show inflation at problem levels. And although growth stalled in April, interest-sensitive sectors such as home and auto sales remain strong, suggesting that interest rates are too low to provide a necessary check on Canadians' spending.

The other factors the central bank will consider, say the economists, is unemployment at a 33-year low, capacity pressures in the economy and sluggish productivity that is contributing to a near 16-year high increase in labour costs.

"The fact is we're coming off an economy that was operating well above capacity and building inflation pressures, the fact that we've had a few weak numbers is not going to stop the bank from what I think is really re-normalizing rates," said Gregory.

"Inflation has been above the bank's target for nine months in a row and it will soon be 10, so sooner or later, the bank is going to have to step in."

Gregory said two events might move the bank from following through on the second tightening measure in September - the loonie rising faster than expected, and the U.S. economy falling flat over the summer months.

"This summer we'll start to see the peak of headwinds blowing in both the housing and mortgage markets, so if the U.S. economy tumbles badly, it could get the bank thinking twice," he said.

The BMO report also predicts that the U.S. Federal Reserve will keep U.S. interest rates on hold indefinitely, but that both England and the European Central Bank will raise rates this summer.

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