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UPDATE 2-Canada growth to surpass potential output -BoC's Leduc

(Adds economist comment, market background)

SHERBROOKE, Quebec, Oct 3 (Reuters) - Canada's economic growth is expected to decline over the next few quarters but continue to exceed the rate of potential output, a top official at the Bank of Canada said on Tuesday in a speech that added another dovish tone to the bank's message.

While he did not directly mention monetary policy, Deputy Governor Sylvain Leduc said a rise in entry rates of new firms and a decline in business exits over the coming quarters could lead to a virtuous cycle of growth.

"An increase in productive capacity resulting from new firm creation would therefore allow the economy to grow faster without creating inflationary pressures," he said.

The focus on rising productivity and higher potential output is "a small step in a more dovish direction" on the path to the bank's Oct. 25 rate decision, Derek Holt, vice president and head of capital markets economics at Scotiabank, said in a note to clients.

The speech prompted little market reaction.

The Bank of Canada raised interest rates twice, in July and September, citing unexpectedly strong economic growth and a need to raise borrowing costs before inflation rears its head.

But financial markets are divided over whether the bank will hike rates again before the end of the year, and economists said Leduc's tone added to the cautious note sounded last week by Governor Stephen Poloz.

"Governor Poloz seemed to try to knock back some of the aggressive expectations for further tightening in the near future ... and with Leduc today not really making any comments on the current outlook for interest rates or inflation, it seems steady as she goes," said Royce Mendes, senior economist at CIBC Capital Markets.

"For investors we think the narrative of further gradual rate hikes continues."

Analysts widely expect the bank will ultimately continue to raise interest rates, but bets on an October rate hike fell after Poloz said there is no predetermined path for rates and future moves from the Bank of Canada will be particularly data-dependent.

Leduc said the sharp depreciation of the Canadian dollar following the 2014-15 drop in oil prices may have contributed to the growth of "gazelles" - young firms that grow quickly. Moreover, the adjustment to the oil shock happened within the anticipated time frame, showing the economy's flexibility.

"That said, significant challenges remain, as our productivity is still well below that observed south of the border," he said. (Reporting by Lorcan Archer in Sherbrooke, Quebec; and Andrea Hopkins and Leah Schnurr in Ottawa; Editing by Dan Grebler and Matthew Lewis)