UPDATE 1-IMF sees Canada economy picking up in 2014, rates on hold
* IMF says economy should grow by 2.25 percent in 2014
* Sees interest rates rising in early 2015
* Projects inflation to reach 2 percent by end 2015
TORONTO, Nov 27 (Reuters) - Economic growth in Canada should accelerate next year as a pick-up in the U.S. recovery boosts exports, but low inflation means the Bank of Canada can wait to raise interest rates until early 2015, the International Monetary Fund said on Wednesday.
The IMF sees Canada's economic growth accelerating to 2.25 percent in 2014 from an estimated 1.6 percent this year. While household consumption has remained robust this year, growth in exports and business investment has disappointed.
As demand and capacity utilization increase next year, business investment is expected to strengthen, particularly spending on machinery and equipment, the IMF said in a report.
"Twelve months ago we were expecting the economy to accelerate over 2013. I have to say, that hasn't happened to the extent to which we were expecting," Roberto Cardarelli, IMF mission chief to Canada, told reporters.
"The culprit is especially exports, which have not picked up as much as we were expecting last year, and business investment, which has slowed over the last few quarters."
The Bank of Canada has also said it is looking for corporate investment and exports to contribute more to growth, picking up from highly indebted consumers who helped fuel the recovery from the financial crisis.
That rotation should happen next year, but hinges on a stronger U.S. recovery, said Cardarelli, who warned risks to the IMF's growth scenario are predominantly on the downside. The United States is Canada's largest trading partner.
Beyond lackluster demand for exports, obstacles hampering the sector include Canada's strong currency, weak productivity growth and capacity constraints in the energy sector, Cardarelli said.
"That casts a little bit of a shadow, or a question mark, over the capacity for Canada to benefit from a recovery of the U.S. economy as much as it used to do in the past," he said.
Another political standoff south of the border over fiscal policy and a faster-than-expected increase in long-term rates as the Federal Reserve looks to wind down its economic stimulus could also affect the U.S. recovery and demand for Canadian exports adversely, the IMF said.
With inflation muted, the Bank of Canada should keep monetary policy accommodative until there are firmer signs that a sustainable transition from household spending to exports and investment is taking hold, the multinational agency said.
It projected the Bank of Canada will lift its main policy rate in early 2015, with the inflation rate climbing back to 2 percent by the end of that year as existing slack in the economy is absorbed. The annual inflation rate dipped to 0.7 percent in October, below the Bank of Canada's target range.
The Bank of Canada surprised markets in October by taking a more dovish stance on monetary policy after 18 months of saying rate hikes were on the horizon. The central bank has held its key interest rate at 1 percent since 2010.
HOMES LESS OVERVALUED
The IMF report warned elevated house prices and household debt could amplify the impact of external pressures, but sees the property sector as less overpriced than it was a year ago.
On a national basis, home prices are overvalued by 5 to 10 percent, down from last year's range of 5 to 15 percent, Cardarelli said.
Canada's post-crisis housing market boom, fueled by record low borrowing costs, has increased fears of a property bubble that could end in a U.S.-style crash. But the market has cooled since the federal government intervened last year to tighten mortgage rules.
"We think that the risk that people wake up in morning and say, 'Oh my God, house prices are too high,' ... and everything falls and that the bubble is going to burst, we don't believe that's the case," Cardarelli said.
"If the economy is going to struggle next year, then the risks around housing are much higher."
The report said that over the long run, Canada should re-examine the need for the country's extensive government-backed mortgage insurance program. Through its housing agency, the federal government insures billions of dollars worth of mortgages for homeowners with low downpayments.
While there are merits to the current system, the IMF said it exposes the federal budget to financial system risks and might distort the allocation of capital away from other uses, such as small business lending.