Canada Markets open in 3 hrs 13 mins

Bank of Canada expected to push interest rates into restrictive territory

FILE PHOTO: A sign is pictured outside the Bank of Canada building in Ottawa

By Julie Gordon and Fergal Smith

OTTAWA (Reuters) - The Bank of Canada is widely expected to deliver yet another oversized interest rate hike next week, lifting its policy rate into restrictive territory for the first time in two decades, but bets are split on whether or not a pause will follow.

BoC Governor Tiff Macklem has made clear the central bank is focused on getting "to the top end or slightly above" the neutral rate, the range from 2% to 3% where monetary policy neither stimulates nor weighs on the economy. The neutral range has declined over the last 20 years.

That should happen on Sept. 7, with money markets leaning toward a hike of 75 basis points, which would take the policy rate to 3.25%. That would be the fourth oversized rate increase this year, capping 300 basis points of tightening since March.

Some economists predict the Canadian central bank may signal a pause after its anticipated hike next week, especially after the release on Wednesday of GDP data that suggested the economy may be cooling faster than expected.

"Having front-loaded rate hikes, the Bank of Canada may want to pause it's hiking cycle allowing the economy time to catch up," said Taylor Schleich, director of economics and strategy at National Bank Financial. Schleich expects a 75-basis point hike on Sept. 7.

"From there, we think it becomes a message of data dependence," he said, noting that inflation and employment data both outweigh GDP in terms of importance to the central bank.

Canadian inflation cooled in July to an annual rate of 7.6% from 8.1% in June, but remains far above the central bank's 2% target, while the jobless rate is at a record low of 4.9%.

Canadian inflation and interest rates https://graphics.reuters.com/CANADA-ECONOMY/INFLATION/byvrjyeneve/chart.png

With underlying price pressures still heating up, money markets are betting on two quarter-percentage-point rate hikes after September, which would lift the policy rate to 3.75% by the end of this year.

Already facing criticism for responding too slowly when inflation started to take off last year, the central bank may be inclined to lean toward a more restrictive stance.

"The Bank of Canada is trying defend its credibility as an inflation targeter," said Andrew Kelvin, chief Canada strategist at TD Securities. "Falling short of market expectations would raise uncomfortable questions around the BoC's commitment to the inflation target."

Still, he sees the market call of a 3.75% policy rate as too steep, expecting it instead to hit a cycle peak at 3.50% in October.

Other economists do not rule out surprises. Doug Porter, chief economist at BMO Capital Markets, noted that nominal spending is "barreling ahead" at its fastest rate - outside the initial coronavirus pandemic bounce - since 1981.

"We now look for a 75-bp hike next week, with an outside chance of a larger move (a la their July 100 bp surprise)," Porter said in a note.

Ultimately, inflation will be the deciding factor.

"At the end of the day, the mandate is 2% inflation. If that doesn't continue to moderate, there will be no choice but to keep things restrictive and keep hiking," National Bank Financial's Schleich said.

(Reporting by Julie Gordon in Ottawa and Fergal Smith in Toronto; Editing by Paul Simao)