* Annual inflation rate at 1.1 percent in August
* Household debt data a signal consumers under strain
* Bank of Canada cut interest rates twice last year (Adds analysts' comment about fiscal stimulus)
By David Ljunggren and Fergal Smith
OTTAWA/TORONTO, Sept 23 (Reuters) - Canada's annual inflation rate in August dipped to a 10-month low and retail sales unexpectedly fell in July, disappointing markets and reviving talk that the Bank of Canada was more inclined to ease monetary policy than tighten.
The data, which reflect the impact of low prices for oil - a key Canadian export - underscore the increasing economic divergence with the United States. The Federal Reserve is expected to raise interest rates by the end of the year.
Statscan said on Friday that the annual inflation rate in August dropped to 1.1 percent, the seventh consecutive month it has stayed below the Bank of Canada's 2.0 percent target.
The closely-watched core rate, which strips out the price of some volatile items, fell to 1.8 percent from 2.1 percent, its lowest level for two years.
The Bank of Canada, which last year cut rates twice to counter the effect of low crude prices, said earlier this month that risks to the profile for inflation had tilted somewhat to the downside in recent months.
Derek Holt, head of capital markets economics at Scotiabank, said the central bank's concerns appeared to be materializing.
"The market will interpret this as keeping a greater risk of a cut than a hike alive over the course of the next year," he said by phone, noting the drop in the core rate.
Indeed, the implied probability of a Bank of Canada rate cut by mid-2017 jumped to nearly 40 percent after the reports, from less than 20 percent before, overnight index swaps showed.
The Canadian dollar weakened, hitting $1.3180 to the U.S. dollar, or 75.87 U.S. cents, at one point.
In its March budget, the Liberal government said it planned to spend C$11.3 billion ($8.6 billion) on infrastructure over the next two years to help support the economy.
Doug Porter, chief economist at BMO Capital Markets, said despite the disappointing data he did not see the need for more fiscal stimulus in the immediate future.
"They (the Liberals) should probably give some time to see what effect the measures they have already unleashed have before they press on the accelerator even faster," he said.
Paul Ferley, assistant chief economist at Royal Bank of Canada, said the stimulus already announced was significant and "should be able to provide the lift that the Canadian economy needs."
Domestic spending has proven to be a bulwark so far but in another sign of trouble for policymakers, household debt as a share of income hit a record high in the second quarter. That suggested consumers are feeling strain.
Canadians also do not appear to have spent much of their increased child benefit checks, which arrived in households in July.
The Bank of Canada had predicted the money should help boost consumer spending.
Although the central bank expects an outsized recovery in the third quarter after a May wildfire in Alberta, the retail sales figures showed little sign of immediate take-off, falling by 0.1 percent weak gas prices.
Additional reporting by Ethan Lou and Susan Taylor in Toronto; Editing by Paul Simao and Daniel Bases