Paul Vieira, Financial Post  Published: Thursday, April 22, 2010

OTTAWA -- First-quarter GDP growth in Canada is expected to hit close to 6% -- the fastest quarterly output in 11 years -- but then expansion moderates through to 2012 due to a stronger Canadian dollar and a "markedly" weaker housing market, the Bank of Canada said Thursday in its latest economic outlook.

The Bank of Canada's quarterly monetary policy report provides more detail to its rate statement released Tuesday, in which the central bank surprised certain quarters of the marketplace by scrapping its conditional commitment to hold its key policy rate at a historic-low until July -- giving it the option to begin raising rates in July.

"The economy has returned to growth and it is clear to everyone there's momentum," Mark Carney, Bank of Canada governor, said a media conference to talk about the bank's outlook. "For Canadians, they can expect a slow improvement -- but an improvement -- in the labour market."

According to the bank's revised outlook, consumer spending is expected to "grow robustly" for the remainder of this year and next, and take over from government in 2011 as the sole source of domestic demand. Afterward, though, the Bank of Canada suggested spending "should dampen" as households deal with higher debt-servicing costs.

The pace of business investment is also expected to intensify, driven by improved conditions and a need to redesign production to meet growing emerging market demand. Inventories are at more "sustainable" levels and should provide support to GDP growth through 2012.

The dollar, which the central bank assumes will trade at US99¢ through to the end of 2012, and the country's relatively poor productivity performance are expected to be drags on economic activity, the bank said.

The central bank sets its key rate to reach and maintain 2% inflation. It said Thursday the risks to the inflation outlook "remain elevated," but roughly balanced over the projection period (which ends at Dec. 31, 2012).

Core inflation in February surpassed the key 2% mark in February, although likely due to one-off effects such as the Winter Olympics. Still, core inflation -- which eliminates volatile-priced items such as food and energy -- has surprised on the upside on the basis of wages largely remaining as is, despite a downturn, and a "significant" rise in regulated prices such as cable, insurance and phone services.

Headline inflation is expected to reach the 2.4% range later this year, the bank said. However, when the new harmonized sales tax in British Columbia and Ontario is excluded, headline inflation should peak at just above 2%.

The report reiterated the upgrade in its 2010 growth outlook, to 3.7% from its previous 3.1% expectation, but then slows to 3.1% in 2011 and 1.9% in 2012 (the 2012 forecast is a reflection of Canada's meagre productivity growth, as the economy won't be able to expand beyond its potential output).

Among the risks to the forecast that the central bank highlighted included a failure to address global trade imbalances, and that issues regarding sovereign risks, especially in Europe, could intensify.

Growth in the first three months of 2010 is set to come in at 5.8%, the biggest three-month gain since the final quarter of 1999 when the Canadian economy expanded 6.8%. This partly reflected consumers taking advantage of record-low borrowing costs and purchase assets such as houses, and improving conditions abroad. Also, the bank acknowledged economic conditions in the United States, Canada's largest trading partner, have improved rapidly, and has upgraded U.S. growth for this year to 3.1% from its previous 2.5% forecast.

But after the first quarter, growth moderates on a quarterly basis, to the mid- to high 3% range for the remainder of the year, and continues to dwindle down to roughly 2% by late 2011.

Mr. Carney said despite the short-term surge, the Canadian economy faces "considerable" challenges in the years ahead that need to be addressed.

"We have some big drags. The [aging population], this is where it starts to bite. Growth will increasingly be determined by our productivity performance, which has not been strong."

More robust business investment will start to yield results, with the central bank expecting productivity to post a 1.4% gain in 2012, compared with the flat readings in past years.

"This is in the hands of the private-sector. If we want to grow faster, we are going to have to grow smarter, work smarter, invest better and build new markets. That remains to be determined."

Investment in housing is projected to "weaken markedly" through the remainder of this year and "well into" 2011, the bank said, adding it expects housing to be a drag on growth next year. Low mortgage rates and the home-renovation tax credit were factors powering strength in the housing market. But that tax break has expired, and mortgage rates have started to climb upward in anticipation of eventual central bank tightening.

Net trade is expected to be a drag on the economy this year. Yet, the central bank notes exports are set to rise through 2012 due to robust emerging-market demand and higher commodity prices. However, the strong Canadian dollar and solid household spending means imports will outstrip sales abroad in 2010. In 2011, net trade is expected to make a small contribution to growth.

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