Bank of Canada holds rates, sees rebound after oil shock

OTTAWA (Reuters) - The Bank of Canada held its benchmark interest rate steady on Wednesday, saying the economy will pick up as non-energy exports and labor markets strengthen even though the oil price crash probably cut economic growth to zero in the first quarter.

A considerable easing in financial conditions largely due to the bank's surprise interest rate cut in January, together with improving U.S. demand, will bolster the transition of Canada's oil-heavy economy to non-energy exports, investment and a stronger jobs market, the bank said.

"As the impact of the oil shock on growth starts to dissipate, this natural sequence is expected to re-emerge as the dominant trend around midyear," it said.

Governor Stephen Poloz had said first-quarter growth would look "atrocious", and Wednesday's Monetary Policy Report downgraded the growth projection for the quarter to 0.0 percent from the annualized 1.5 percent the bank had forecast in January.

This widened Canada's output gap and put additional downward pressure on inflation, but the bank said the anticipated growth recovery means "that the output gap will be back in line with its previous trajectory later this year." It sees 1.8 percent growth in the second quarter and 2.8 percent in the third.

Canada is a major oil exporter, and the bank said it would have to monitor closely the effects of cheaper oil. It said that although the impact was more front-loaded than it had estimated, the base-case scenario is that it will not be larger overall.

It said, however, there is a risk the impact could be larger if oil prices continue to fall in the near term, though it believes prices are likely to recover in the medium term.

The bank noted that while overall inflation was at 1 percent, due to cheaper energy, core inflation had remained close to the bank's 2 percent target. "The temporary effects of sector-specific factors and pass-through of the lower Canadian dollar have offset the disinflationary forces from slack in the economy," it said.

It boosted by 1/4 percentage point its estimate of excess capacity in the economy to between 1/2 percent and 1-1/2 percent. It continued to forecast the economy will reach full capacity around the end of 2016.

Risks to its inflation outlook are now roughly balanced and risks to financial stability appear to be evolving as expected, with a soft landing in the heated housing sector still the most likely scenario, it said.

(Editing by Peter Galloway)