(September 8, 2004) For the first time in nearly a year-and-a-half, the Bank of Canada has raised interest rates, bumping up the overnight lending rate 25 basis points to 2.25%.

In a statement accompanying today’s decision, the central bank noted that economic growth in the first half of the year was stronger than expected, “largely as a result of more robust external demand for Canadian goods and services.”

The bank added that with the economy currently operating at close to capacity, “monetary stimulus needs to be reduced to avoid a buildup of inflationary pressures,” suggesting that interest rates could go even higher later this year in an effort to prevent the economy from overheating.

At the same time, the bank pointed to three key factors that could affect monetary policy going forward: the output gap, growth of Canadian imports and exports, and oil prices.

“The bank is wise to point to the large amounts of uncertainty surrounding each of these factors,” says RBC economist Derek Holt. Output gaps — which signal the spread between supply and demand pressure in the economy — are notoriously subject to measurement challenges, he points out.

In addition, the growth path of Canadian exports and imports is uncertain and predicting oil prices is a “humbling exercise at best,” Holt concedes. After flirting with the $50 per barrel level a few weeks back, oil prices have slipped to around $43, with Holt noting that there’s a huge $20 spread on consensus forecasts on where crude prices will be this time next year.

Despite those risk factors, Holt says RBC’s forecast for future interest rate movements in Canada is unchanged, predicting two quarter point hikes before the end of the year.

Sherry Cooper, chief economist at BMO Nesbitt Burns, agrees, saying that it will take a lot to convince the bank not to raise rates again at its next meeting in October. “Even a soaring loonie is unlikely to stop the bank, especially since the economy has readily shrugged off last year’s surge in the currency,” she says.

“It’s onward and upward for short term Canadian rates,” says Cooper.

TD’s Craig Alexander also expects the key overnight lending rate to hit 2.75% by the end of the year, and goes even further, predicting rates to go as high as 4% by the end of 2005.