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OTTAWA (Reuters) - Canada's core inflation rate, which helps guide central bank interest rate decisions, unexpectedly slowed to a two-year low of 1.5 percent in December, leaving the door open for further rate cuts.
Core inflation, which excludes volatile items like gasoline and fresh produce, eased from 1.6 percent in November after prices fell 0.3 percent in the final month of the year.
Retailers came under pressure late last year to slash prices to lure back shoppers who were taking advantage of the stronger Canadian dollar by crossing the border to shop in U.S. malls.
The annual core rate matched that of December 2005. The last time it was lower was in July 2005 at 1.3 percent.
Analysts had forecast a 0.1 percent monthly decline in consumer prices and an annual core rate of 1.7 percent.
Total year-on-year inflation also eased in December, sliding to 2.4 percent from 2.5 percent in November. Prices edged up 0.1 percent on the month, in line with forecasts.
A moderation of the increase in gasoline prices and a decline in motor vehicle prices explained the softer number, Statscan said.
The Canadian dollar fell after the data to C$1.0094 to the U.S. dollar, or 99.07 U.S. cents, from around C$1.0061 to the U.S. dollar, or 99.39 U.S. cents. Bonds rose slightly.
But markets were not too surprised by the low price growth, which the Bank of Canada anticipated in quarterly projections on Thursday. The bank targets inflation at 2 percent but is comfortable with a range of 1 percent to 3 percent.
"I don't think anyone in Canada is particularly worried about inflation getting in the way of a March rate cut," said Stewart Hall, market strategist at HSBC Canada.
The Bank of Canada cut rates by a quarter-point on Tuesday for the second straight month and has signaled it will cut rates more in the future. Most primary securities dealers expect a half-point cut on March 4.
Low inflation gives the bank more room to slash rates to prop up the economy in the face of a growing risk of a U.S. recession. But Governor David Dodge suggested on Thursday strong domestic demand and capacity pressures could hold the bank back from aggressive rate cuts.
"It's the battle of the Titans, with the Canadian dollar on one side and tight capacity on the other... A low unemployment rate and difficulty meeting demand just don't seem to be relevant factors right now for Canada," said Eric Lascelles, chief rates and economics specialist at TD Securities.
Most of the upward pressure on prices in 2007 came from gasoline prices, which rose 14.9 percent. However, that was down from the 17.6 percent increase in the 12 months to November.
Mortgage interest costs, homeowners' replacement cost and food were also big contributors to inflation, while downward price pressure came from purchase and leasing of motor vehicles, computer equipment and supplies and fresh fruit and vegetables.
The bank sees core inflation at 1.4 percent in the first quarter and 1.3 percent in the second quarter before moving back up toward its target.
"It's the risk of core inflation dipping below the 1 percent band around the 2 percent target that could get the Bank to ease more aggressively," said Michael Gregory, senior economist BMO Capital Markets.
Additional reporting by John McCrank in Toronto