OTTAWA - The Bank of Canada is warning it is prepared to intervene to ensure Canada's fragile economic recovery is not derailed by a resurgent loonie.

With evidence mounting that the economy is emerging from a short but deep recession, deputy governor Timothy Lane cautioned Tuesday that the recovery is still uncertain and the loonie's strength is worrying.

"The Canadian economy is expected to start growing again this quarter," Lane told a business audience in Kingston, Ont., adding that signs of growth are also appearing in the United States and the global economy.

But he noted that much of that growth to date has been on the back of government and central bank stimulus and he cautioned that should the loonie continue to rise, it could undermine the recovery.

"A persistently strong Canadian dollar could reduce real growth and delay the return of inflation on target," he said.

"If a stronger dollar were to alter the path of projected inflation ... we would need to take that into account."

A high dollar hurts exporters because it makes Canadian exports to the United States more expensive for American buyers forcing them to seek cheaper alternatives and buy products from American or overseas companies instead.

Strength in the loonie has hurt the Canadian forestry sector particularly hard, squeezing sales of paper, lumber and building products, leading to mill closures and job cuts in Canada.

It is not the first time the central bank has warned about the strong loonie, but the strong language adopted by Lane suggests the central bank is setting the stage for a response, if necessary.

Lane acknowledged that with the key policy rate at 0.25 per cent, the central bank's traditional tool for cooling the currency - cutting interest rates - is no longer available. Still, the deputy governor said the bank retains considerable powers, including initiating a regime of quantitative easing.

Quantitative easing - which entails the bank purchasing government treasuries - would likely have the impact of lowering bond yields and increasing the money supply, thereby making the loonie less attractive.

The remarks had an immediate impact on trading Tuesday. The dollar, which had been trading below 93 cents U.S. most of Tuesday, dropped further after the text of Lane's speech were posted on the bank website before closing at 92.1 cents U.S., down 0.75 of a cent.

On Tuesday, there were strong signals the U.S. economy, which is essential to Canada's large export sector, was poised to recover.

A closely watched index showed U.S. home prices rose three per cent in the second quarter, the first quarterly increase in three years, although prices remain 15 per cent lower than last year.

And the Conference Board index of consumer confidence rose almost eight points to 54.1 in August, reflecting rising expectations about future economic conditions.

Despite the good news, the Bank of Canada has good reason to worry that the loonie could undercut a big part of what has been achieved, said TD Bank's chief economist Don Drummond.

"They will have a problem if the Canadian dollar strengthens a lot independent of a rise in commodity prices, and that is our expectation. Our forecast is that the dollar hits parity at the end of the year," he said.

Still, Scotiabank economist Derek Holt said the central bank has shown in the past that it often guesses wrong when it tries to intervene in currency fluctuations, and Drummond questioned the bank's ability to move the currency significantly through quantitative easing.

"Their own calculations suggest they would have to buy over $1 billion (in treasury bills) to move the long-term interest rates even 10 basis points," he said.

Despite the cautions, Lane did not retreat from bank's July forecast that the recession in Canada was at an end, and that growth would resume this quarter, the July-September period.

He predicted the economy would advance by three per cent next year and 3.5 per cent in 2011, but those assumptions was based on the premise that the loonie would average about 87 cents U.S.

Given the unco-operative currency and other uncertainties, Lane said the challenge for police makers will be "managing the recovery" as intently as they devoted to the crisis.

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