The Bank of Canada hinted today a "modest" increase in interest rates "may become appropriate" if inflation rises over the medium term.

The central bank, in its latest monetary policy report, said the timing and degree of any increase "will be weighed carefully against domestic and global economic developments."

The report comes a day after the central bank announced it was keeping its benchmark bank interest rate unchanged at one per cent, but hinted strongly that it is uncomfortable with super-low rates that encourage Canadians to borrow more than they should.

And it devoted a special analysis to global oil prices, which have increased by about 15 per cent from their trough in October 2011.

Canadians, it said, are losing out because of the price run-up, which is impacting everything from business input costs to consumer spending and inflation.

Central and eastern Canada have been importing high-priced Brent crude pumped in the North Sea and exporting lower-priced oil from Alberta since January, negatively impacting overall trade.

"The increase in the price of our oil imports raises production costs for Canadian firms and also puts upward pressure on gasoline prices, since about half of the gasoline purchased in Canada is produced using refined petroleum priced off Brent," the bank said.

Rising oil dampens demand

That puts downward pressure on Canada's real gross domestic income, dropping the country's spending power to buy foreign goods and services, the bank said. In turn, it also dampens spending on domestically produced goods and services.

In the past, increases in oil prices have been beneficial to Canada because the country exports more than it imports.

But an oversupply at the Cushing, Okla., refining hub and supply factors, including refinery outages and inadequate pipeline capacity, are contributing to the undervaluing of Western Canadian crude.

The economy is steadily gaining strength but is still being constrained from robust growth by heavy household debt, a strong dollar, soft export markets and weak employment growth, it said.

In a special section within the report, the bank estimated that Canadians are borrowing on rising home values to an unsustainable degree.

Home equity lines of credit and mortgage refinancing has grown from about $8 billion in 2001 to $64 billion in 2010, with about half of that "equity extraction" going into consumption or to pay off other debt.

'Home equity extracted through additional borrowing cannot fund higher consumption indefinitely.' —Bank of Canada

"Home equity extracted through additional borrowing cannot fund higher consumption indefinitely," the bank warns.

"With less equity in their homes, households would also be more exposed to a decline in house prices, which could further dampen consumption."

"Growth in residential investment, which is currently supported by very favourable mortgage financing conditions, is forecast to slow," it states, but the ratio of household spending to GDP will likely remain high.

"In that context, the ratio of household debt to income is projected to rise further," the bank concluded.

Growth in the Canadian economy, it expected, will be 2.4 per cent through the end of 2013.

For this year, that's up from the bank's prediction in January for two per cent expansion, but is a lowering of its expectations for 2013 by 0.4 percentage points.

It also predicted a return to full capacity for the first time since the recession by the first half of 2013 — as much as six months earlier than anticipated.

BMO economist Michael Gregory predicted that the bank will start raising rates around the end of this year or early next, if it believes its prediction for reaching full capacity is on course.

The TD Bank's Francis Fong suggested a hike of no more than one percentage point over the next year and a half , especially with the U.S. Federal Reserve likely on hold until 2014.

"Disproportionate Canadian rate hikes would lead to enormous pressure on the loonie — something the Bank of Canada has little appetite for given the already uneven recovery in the export sector," said Fong

"Moreover, the European debt crisis is far from over. Although Greece has managed to overcome many of its fiscal hurdles, Spain is fast emerging as the next major risk."

Fong suggested a slight rise this year, then a pause to assess the impact before tightening again in 2013

Global growth estimate rises

The stronger outlook for 2012 reflects the bank's improved outlook for global growth that it raised to 3.2 per cent from the previous 2.9 per cent.

That's based mainly on an expected increase in U.S. expansion, which it predicted will reach 2.3 per cent, an upgrade from its two per cent projection in January.

It expects expansion to moderate to 2.2 per cent in 2014.

"This outlook for the Canadian economy is slightly firmer than in the January report, with greater momentum through 2012 than had been anticipated," the bank said.

"The profile for growth in consumption and investment is more front-loaded than previously expected, in part reflecting a more rapid improvement in confidence."

The bank also upgraded its inflation outlook, expecting consumer price increases to remain above two per cent throughout 2012 before returning to a two per cent average next year.

It also raised its estimate for the average exchange rate for the loonie to $1.01 US, from 98 cents in its last report.

The bank says not all is rosy in Canada or around the world, with the potential of a nasty debt crisis still looming over Europe.  

On Canada's labour market, the bank suggested concerns from firms about labour shortages in Canada are a myth, at least for most of the country.

It noted the employment and unemployment rates remain unchanged from their levels six months ago, and that the proportion of "involuntary part-time workers" has only partially recovered "pointing to the persistence of unused capacity in the labour market."

With files from The Canadian Press