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OTTAWA (Reuters) - Canada's inflation rate softened more than expected in January, driving the Canadian dollar lower and spurring expectations that the central bank will cut interest rates aggressively next month.
A big drop in vehicle prices in January pushed consumer prices down by a sharper-than-expected 0.3 percent for an annual inflation rate of 1.1 percent, Statistics Canada said on Friday.
That is below the Bank of Canada's 2 percent target and down from 1.2 percent in December. The bank aims to keep inflation within a range of 1 percent to 3 percent.
The core rate, closely watched by the central bank because it excludes volatile items like gasoline, also fell more in January than forecast at 0.4 percent for an annual rate of 1.9 percent.
Analysts in a Reuters poll had forecast 0.1 percent declines in both the overall consumer price index and the core index in January.
"It was certainly weaker than anticipated ... I guess that is not too out of line with what's happening in our economy, which seems to be falling off a cliff pretty quickly," said Sal Guatieri, senior economist at BMO Nesbitt Burns.
"There will be more pressure on the Bank (of Canada) to cut interest rates in March," he said.
Following the data, the Canadian dollar fell to C$1.2635 to the U.S. dollar, or 79.15 U.S. cents, from Thursday's close of C$1.2593 to the U.S. dollar, or 79.41 U.S. cents. It later recovered a bit.
Bond prices rose on a combination of the lower inflation figures and a rally in the U.S. Treasury market. The interest-rate sensitive two-year bond was up 8 Canadian cents at C$102.68 to yield 1.212 percent, while the 10-year bond rose 70 Canadian cents to C$111.55 to yield 2.824 percent.
The speed of the drop in consumer prices in Canada may have surprised analysts, but the direction likely did not. The Bank of Canada has predicted -- and markets agree -- that the economy is headed for a short period of falling prices year-on-year in the second and third quarters of this year.
However, the bank has said core inflation, considered a more reliable gauge of underlying price trends, will stay within the target range.
"The profile for core CPI is clearly downward, and it questions the Bank of Canada's assumption that core would not fall lower than 1 percent, but I think at this point in time we only consider that a risk and not a base case scenario," said Matthew Strauss, senior currency strategist at RBC Capital Markets.
"As far as monetary policy is concerned it opens the door wide for another 50 basis-point (interest-rate) cut in March," he said.
Derek Holt, economist at Scotia Capital, cautioned against reading too much into the decline in core inflation because it was narrowly based on transportation prices.
"So it's not as symptomatic of a broad-based retreat in prices in Canada as one might be led to believe," he said.
The Bank of Canada has already cut its key overnight rate by 350 basis points in the past year to a 50-year low of 1 percent. Governor Mark Carney has said there is still plenty of flexibility in monetary policy, suggesting another cut on March 3, when most analysts expect it to cut by a half-point to 0.5 percent.
The cost of buying or leasing a vehicle slid 5.3 percent in January, Statscan said. Travel and natural gas prices also contributed to the dip in the CPI. But the slide would have been more severe had it not been for a partial recovery in gasoline prices after they plunged at their fastest pace in a half-century in December.
In the 12-month period, vehicles, gasoline and other fuels pressured prices lower while upward pressure came from mortgage interest costs, fresh vegetables and natural gas.
Additional reporting by Toronto Treasury team; Editing by Peter Galloway