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OTTAWA (Reuters) - The Bank of Canada continued to signal it might have to raise interest rates on Tuesday but it softened its recent hawkish language a bit in reaction to a sharp deterioration in global financial conditions sparked by renewed fears about Europe.
The central bank kept its key overnight rate at a low 1 percent, saying that while an increase might still be needed, it would depend on the strength of economic growth.
"To the extent that the economic expansion continues and the current excess supply in the economy is gradually absorbed, some modest withdrawal of the present considerable monetary policy stimulus may become appropriate...," the bank said.
Amid the deepening euro zone crisis, analysts had waited to see if and how the central bank might temper the language it used in its April 17 decision to keep its rate at a stimulative 1 percent. At that time the bank said a modest rate increase might become appropriate "in light of the reduced slack in the economy and firmer underlying inflation".
In the end, the market focused more on Tuesday on the fact that Governor Mark Carney still saw the possibility of higher rates than on the conditions he said would have to be in place before the bank raised them.
"This was an opportunity for Governor Carney to manage Street expectations. The Street has been suggesting a rate cut, or certainly bias for a rate cut, with respect to the futures market," said Jack Spitz at National Bank Financial.
"The market consensus was getting ahead of itself with respect to the next move being a cut, and he successfully scaled back those expectations. As a result we've seen a move higher for the Canadian dollar."
The Canadian currency strengthened to C$1.0383 against the U.S. dollar, or 96.31 U.S. cents, after the bank's statement from Monday's close of C$1.0397, versus the greenback, or 96.18 U.S. cents.
Canadian bond markets were mostly lower. Canada's two-year bond fell 7 Canadian cents to yield 1.007 percent, while the benchmark 10-year bond dropped 32 cents to yield 1.711 percent.
The bank said that while momentum in the Canadian economy was largely on track, the global growth outlook has weakened in recent weeks.
"Some of the risks around the European crisis are materializing and risks remain skewed to the downside," it said.
It said that while the U.S. economy was continuing to grow modestly, emerging economies were slowing faster and a bit more broadly than expected. Slower global momentum and heightened financial risk aversion have cut prices for the commodities Canada produces, it said.
Canadian households have continued to add to their debt burden amid modest income growth, the bank said. It saw the recovery in net exports staying weak because of modest external demand and competitive challenges, including the Canadian dollar's persistent strength.
The bank signaled a slightly weaker profile for inflation, with overall inflation falling below 2 percent in the short term because of cheaper gasoline. Core inflation, which excludes gasoline and other items, will remain around 2 percent, it said.
Previously, it had expected CPI inflation to decline in the near term but remain close to 2 percent.
A Reuters survey of analysts taken before the rate decision predicted the bank's overnight rate would rise in the first quarter of 2013.
The futures market has instead largely priced in an actual rate cut by the end of this year. After Tuesday's statement futures were still pointing to a cut, but only about a 50 percent chance of one by year-end.
Additional reporting by Euan Rocha, Jennifer Kwan, Andrea Hopkins and Julie Gordon; Editing by Bernadette Baum; and Peter Galloway