Bank of Canada holds rates (Reuters)

OTTAWA (Reuters) – The Bank of Canada warned on Tuesday that it would eventually have to lift borrowing costs if the economy continues expanding, introducing some hawkish language that caught many in the market off guard.

The statement by the central bank -- which kept its key interest rate unchanged at 1 percent -- drove the Canadian dollar and short-term bond yields higher as traders increased bets on rate hikes later this year.

"To the extent that the expansion continues and the current material excess supply in the economy is gradually absorbed, some of the considerable monetary policy stimulus currently in place will be eventually withdrawn, consistent with achieving the 2 percent inflation target. Such reduction would need to be carefully considered," the central bank said in a statement.

The markets interpreted "eventually" to mean not the next rate decision in July but rather September or -- even more likely -- October or December.

Previous statements had only said that any future hikes "would need to be carefully considered."

"It doesn't sound like the central bank is gearing up for a rate hike in July but the warning that rate hikes will eventually come suggests that we'll see a few hikes before the end of the year," said CIBC chief economist Avery Shenfeld.

"Markets had priced out nearly all of the risks of a hike not only in July but September as well. I think the bank was uncomfortable with the market starting to assume that it was going to wait forever to begin hiking."

Overnight index swaps, which trade based on expectations for the key central bank policy rate, showed investors see less than a 5 percent chance of a rate hike in July.

But swaps traders did increase the probability that the central bank will tighten at some point after July. The central bank has scheduled policy announcements in September, October and December.

The central bank became the first in the Group of Seven advanced economies to tighten monetary policy following the global financial crisis, hiking three times from June-September last year but pausing since then due to the weak global recovery.

SUBTLE SHIFT IN LANGUAGE

The bank now sees underlying inflation as only "relatively subdued" rather than "subdued" as in previous statements, but it did not change its overall outlook for inflation.

"It's a subtle change. And I think that's the theme here. They certainly didn't bang us over the head with any obvious changes, but there were a few very subtle shifts in the language," said BMO Capital Markets deputy chief economist Doug Porter.

"I do think they are eventually preparing the ground for rate hikes, but there's very little here to suggest that the bank has had a big change of heart. It's likely to be some time yet before they start raising rates."

Bank of Canada Governor Mark Carney has said in the past he does not want Canadian rates to diverge too far from U.S. rates, which are not likely to rise in the near future, but he also has to guard against overheating in Canada.

The bank statement repeated that the persistent strength of the Canadian dollar "could create even greater headwinds for the Canadian economy" and dampen inflation.

And temporary supply chain disruptions from Japan will sharply restrain growth in the second quarter. But it expects this to be unwound in subsequent quarters.

It said the U.S. economy continued to grow modestly and European growth was maintaining momentum, but risks to peripheral European economies had increased.

The Canadian dollar climbed as high as C$0.9653 to the U.S. currency, or $1.0359, up from C$0.9723 to the U.S. dollar, or $1.0285, immediately before the Bank of Canada statement. It was the Canadian dollar's strongest level since May 20.

Short-dated bond prices, which are most sensitive to the interest rate outlook, deepened losses after the Bank of Canada news.

(With additional reporting by Claire Sibonney, Ka Yan Ng and Solarina Ho in Toronto; Editing by Jeffrey Hodgson)

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Taxes to Balance the Budget? Not Unless Rates Go Up 150 Percent, Study Says

Public Notice

A table by Public Notice shows how much more taxpayers would have to pay of their income in order to match current spending.

It's Tax Day, and the Washington chatter is all about whether America's top earners should be taxed more.

But, as the dim outlook from a key ratings agency showed Monday, Uncle Sam's deficit problem is deep. And if the federal government really wanted to use the tax code to close the deficit, it turns out everybody would feel the burn.

A new Tax Day study showed that if Washington wanted to balance the budget using tax increases alone, rates would have to more than double across the board -- including on the middle class -- to keep up with federal spending.

As Republicans often argue, the top tier already pays a greater percentage in taxes than all the rest. The government could extract hundreds of billions more by upping their rates, but without significant spending cuts would have to turn next to the middle brackets.

"Everyone would be looking at a tax hike if that's the answer here," Public Notice director Gretchen Hamel said.

IRS data showed that in 2008, the top 5 percent of earners -- households earning more than $160,000 -- accounted for about 59 percent of all federal income tax paid. The next 45 percent -- solidly middle-class taxpayers earning between $33,000 and $160,000 -- accounted for about 39 percent of all personal income tax paid.

The bottom 50 percent accounted for the remaining sliver of tax revenue. In fact, a Tax Policy Center study showed that 45 percent of households in the United States will pay no federal income tax for 2010.

White House spokesman Jay Carney said Monday that those households do pay taxes. 

"There are many taxes besides income taxes," he said. "Those who are paying payroll taxes, are working Americans, they very much have a stake in the system and they very much have a stake in the economic future of this country."

President Obama has said emphatically that he will not allow the tax rate on families earning more than $250,000 to remain at 35 percent after 2012, a source of contention among Republicans who say the top earners are already carrying the brunt of the "shared sacrifice." 

Meanwhile, critics warn that tax hikes will, in all likelihood, have a limited impact on the deficit -- unless they are raised beyond recognition.

The estimate from the nonpartisan Public Notice demonstrated this point. It showed that if Washington wanted to hoist tax rates to actually cover spending, the top tier rate would go from 35 to 88 percent; the middle tier from 25 to 63 percent and the lowest from 10 to 25 percent.

"You'd have to more than double taxes and you still wouldn't solve this problem," Hamel said. "And the problem is spending."

Obama is targeting his proposed increase on the top 2 percent of wage earners, casting it as a hike on millionaires and billionaires. He argues they can afford to pay a little more to help the country balance its books.

But as one might expect, virtually nobody thinks they’re taxed too little -- though the burden varies drastically across the income scale.

A new Gallup poll released Monday showed that while 57 percent of Americans describe their income tax as "fair," most think their taxes are still too high. The more an individual made, the stronger they felt on that question, the poll showed.

The Obama administration emphasizes that its deficit reduction plan leans more on spending cuts than tax increases. The administration is looking at $1 in revenue increases for every $3 in spending cuts. That's about the ratio being eyed by the "gang of six" senators working on a bipartisan compromise.

But Sen. Mark Warner, D-Va., a member of that group, said in an interview Sunday that the revenue increases don't have to come from tax rate hikes. Rather, he stressed that lawmakers could instead cut back on deductions and other loopholes that are costing the U.S. Treasury.

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