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Slowing inflation adds pressure on BoC to hold rates

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Bank of Canada Governor Mark Carney may warn that he's prepared to hike interest rates, but July's inflation figures provide another counterpoint to his hawkish tone.

Annual inflation slowed to 1.3 percent in July from 1.5 percent in June, Statistics Canada reported on Friday.

Economists were expecting annual inflation to come in at 1.5 percent.

More importantly, the Bank of Canada's annual core index, which strips out eight volatile items, such as food and energy, fell to 1.7 percent, down from a 2-percent gain in June. That's below the central bank's mid-point inflation target of 2 percent.

Many economists now expect third-quarter inflation to come in below the central bank’s 1.9-percent forecast.

And July's slowdown in annual inflation isn't simply a one-off event. The three-month and six-month annualized core inflation figures are sitting at negative 0.3 percent and 1.2 percent, respectively.

The June to July drop in prices marks the third consecutive month of declining prices. The last time the Canadian economy posted three consecutive months of falling prices was during the most recent recession, according to economists at Capital Economics.

"With inflation remaining subdued and the downside risks to global economic growth threatening even lower inflation, interest rates are likely to remain low for a long time yet," says Capital Economics economist David Madani.

He expects other figures to continue to keep inflation in check and further push the Bank of Canada to the sidelines.

"Economic growth over the second half of this year and next is likely to slow, especially now that Canada's housing market is self-correcting," Madani says. "With unemployment likely to rise as a result, inflation will remain muted this year and next."

The July inflation figures are likely to temper investors’ expectations for a rate hike.

"Just when markets swung to pricing in rate hikes by the Bank of Canada, July’s inflation data are one strike against fears that Carney and Co. will pull the level on rates any time soon," says CIBC economist Emanuella Enenajor.

The weaker-than-expected inflation figures come after a report last week showed the Canadian economy shed 30,400 jobs in July, after two months of modest employment gains of about 7,000 jobs.

The unemployment rate ticked up to 7.3 percent in July from 7.2 percent in June -- the same level it was last year and marking the first time in more than two years that the jobless rate did not dip below its year-ago level.

The combination of a potentially weakening labour market and slowing inflation means the Bank of Canada has little reason to hike rates -- even though Carney recently gave an interview in which he said the economy was “almost back at full capacity” and the country’s financial system was “firing on all cylinders.”

In July the Bank of Canada maintained its benchmark interest rate at one percent for the 15th consecutive time and lowered its growth forecasts.

It now expects the economy to grow 2.1 percent in 2012, below its previous forecast of 2.4 percent. It also lowered its forecast for 2013 to 2.3 percent from 2.4 percent.

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