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BMO Financial Group

July 08, 2011 12:13 ET

Rate Hikes to Return in Fall, but Pause Next Summer-BMO

- "New Neutral" rate nearly half of historic norm - mostly owing to strong dollar

- BMO encourages potential home buyers to stress-test their mortgage ahead of possible interest rate increases

- BMO survey shows that two-thirds of Canadians say they will still be able to service their mortgage payments if interest rates go up

TORONTO, ONTARIO--(Marketwire - July 8, 2011) - Given the outlook for above-potential economic growth for the third quarter of 2011 and beyond, BMO Economics has issued a new report projecting a resumption of rate hikes by the Bank of Canada in October of this year.

"In its latest policy announcement on May 31, the Bank of Canada said that monetary stimulus would have to be 'eventually withdrawn'. However, this was not a signal of imminent rate hikes and a return to historical 'neutral' levels," said Michael Gregory, Senior Economist, BMO Capital Markets. "Governor Carney has indicated that the Canadian economy still faces 'considerable headwinds', namely a weak U.S. economy and strong Canadian dollar. Rates will surely rise, but by less than what past cycles would dictate.

"After a follow-up increase in December, the continued strength of the Canadian dollar will likely elicit another policy pause, one that will probably persist until the Fed is much closer to hiking rates," noted Mr. Gregory. "This will leave the Bank's benchmark rate at 2.5 per cent by the end of 2012. This 'new neutral' is around half the historic norm, mostly owing to the super-strong loonie."

Mr. Gregory added that the possible increase in interest rates could spur a relative cooling in some of Canada's major housing markets, including Toronto and Vancouver, with the potential for some softening in house prices.

However, while there may be price relief, Katie Archdekin, Head of Mortgage Products, BMO Bank of Montreal, noted that it remains increasingly important that potential homebuyers stress-test their home buying budgets to account for the added costs that could come with the projected rate increase.

"We've been urging Canadians for some time now to prepare for interest rates to climb eventually; one way for home buyers to do this is to base their home financing budget on a higher interest rate to provide a cushion in the event of interest rate hikes," said Ms. Archdekin. "Our recent survey data shows that the majority of homeowners are confident they will be able to sustain their mortgage payments if interest rates rise, which is a good sign that the message is hitting home," said Ms. Archdekin.

Ms. Archdekin added that based on the average household income in Canada, a typical new home buyer uses just over one-third of their average household disposable income to service their housing costs today, in line with historical norms.

BMO Economics' report, entitled "Bank of Canada Policy: Rate-Hike-Free 2011 Still Unlikely" and appearing in their weekly Focus publication, is available at bmocm.com/economics.

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