The Bank of Canada (BOC) maintained its policy rate at 1.0 percent, as widely expected, but cautioned that inflation "is expected to remain well below target for some time, and therefore the downside risks to inflation have grown in importance" despite an apparent strengthening of the fundamental drivers of economic growth and future inflation.
The BOC, which has maintained its target for the overnight rate at 1.0 percent since September 2010, said inflation was now expected to be lower than previously expected and first return to the bank's target in about two years as the effect of heightened competition in the retail sector and excess capacity in the economy is absorbed.
The central bank, which dropped a slightly tightening bias in November, was neutral in its policy guidance, saying the "timing and direction of the next change to the policy rate will depend on how new information influences this balance of risks."
Among the risks identified by the BOC is high household debt, which the BOC said had not materially changed, though it added that recent data confirmed that the housing market is undergoing a soft landing and the ratio of household debt to income is stabilizing.
In its latest policy report, the BOC trimmed its forecast for inflation this year compared with its October projection but maintained the forecast that headline inflation would hit the bank's 2.0 percent target by the fourth quarter of 2015.
The forecast of economic growth this year was raised while the forecast for 2015 was lowered.
"Real GDP growth is projected to pick up from 1.8 percent in 2013 to 2.5 percent in both 2014 and 2015. This implies that the economy will return gradually to capacity over the next two years," the BOC said.
The BOC sees annual growth in Canada's real Gross Domestic Product up by 2.3 percent in the first quarter of 2014, up from October's forecast of 2.0 percent, 2.5 percent in the second quarter, up from 2.2 percent, 2.5 percent in the third quarter, up from 2.4 percent and 2.5 percent in the fourth quarter, also up from 2.4 percent previously forecast.
"Stronger U.S. demand, as well as the recent depreciation of the Canadian dollar, should help to boost exports and, in turn, business confidence and investment," the BOC said, adding that it has yet to see strong signs of a rebalancing of growth towards exports and business investment.
Canada's GDP rose by 0.7 percent in the third quarter of 2013 from the second quarter for annual growth of 1.91 percent, the highest pace in five quarters.
The BOC forecast headline inflation of 0.9 percent in the first quarter of this year, down from a previous forecast of 1.2 percent, 1.2 percent in the second quarter, down from 1.4 percent previously forecast, 1.4 percent in the third quarter, down from 1.6 percent, and 1.5 percent in the fourth quarter. down from October's 1.7 percent forecast.
In November, Canada's inflation rate rose slightly to 0.9 percent from October's 0.7 percent.
Canada's dollar has been under downward pressure since September 2012 when it hit a post-financial crises high of 1.032 to the U.S. dollar as global investors sought safe haven.
But its decline has accelerated this year, trading at 0.91 cents to the U.S. dollar today from 0.94 at the end of 2013, reflecting improved growth prospects in the United States. In its previous policy report from October, the BOC had expected an exchange rate of 97 cents to the U.S. dollar.