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OTTAWA (Reuters) - The Bank of Canada extinguished speculation on Tuesday that it would follow Australia in hiking interest rates quickly, warning that favorable economic developments were being undermined by the strength of the Canadian dollar.
The bank kept its key overnight interest rate at a very low 0.25 percent and reiterated its intention to keep it there through mid-2010.
Far from giving any suggestion of an early exit from its extended low-rate strategy, which is designed to stimulate the economy, the bank said return to economic normalcy would be delayed.
It said the output gap, reflecting excess supply in the economy, would not be closed until the third quarter of 2011, three months later than it had earlier forecast. It also forecast that inflation would not return to its 2 percent target until third quarter 2011, also a three-month delay.
The bank's renewed commitment to keeping rates low and its forecast of delays in the economy's turnaround helped weaken the Canadian dollar to C$1.0470, or 95.51 U.S. cents, by mid-morning from C$1.0320, or 96.90 U.S. cents, just before the report.
"Financial markets have been starting to price in the possibility of a (rate) hike in March," Royal Bank of Canada assistant chief economist Paul Ferley said. "So I think reiterating that commitment is possibly an attempt to take some of the steam out of the Canadian dollar."
The Reserve Bank of Australia surprised markets on October 6 with a 25 basis-point rate hike, becoming the first of the Group of 20 central banks to tighten credit as the global financial crisis eases.
There had been speculation in markets that the Bank of Canada could also opt for an early rate rise due to a spate of encouraging economic data.
The bank did say on Tuesday that global economic and financial conditions have been somewhat better than it forecast in July.
Resumption of growth in Canada has been supported by monetary and fiscal stimulus, increased household wealth, improving financial conditions, higher commodity prices and stronger business and consumer confidence, it said.
"However, heightened volatility and persistent strength in the Canadian dollar are working to slow growth and subdue inflation pressures. The current strength in the dollar is expected, over time, to more than fully offset the favorable developments since July," it said in its statement.
Canadian government bond prices firmed after the statement with the yield on the two-year bond falling to 1.545 percent from 1.618 percent beforehand.
"(The statement) solidifies the conditional commitment they've had in place for some time and it also suggests that they're not necessarily going to move policy aggressively any time soon," Credit Suisse economist Jonathan Basile said.
The bank said growth in Canada in the second half of this year would be slightly higher than previously projected but that growth over the rest of its projection period would be slightly lower on average than it had forecast earlier.
The central bank said the economy would shrink by 2.3 percent this year, compared with the -2.4 percent it forecast in July.
It forecast economic growth of 3.0 percent in 2010, but cut its forecast for growth in 2011 slightly to 3.3 percent from 3.5 percent.
It repeated that the underlying risks to its projection were roughly balanced but said that because it cannot cut rates any further, the overall risks were slightly tilted to the downside.
Additional reporting by Frank Pingue, Ka Yan Ng and Jennifer Kwan; Editing by Peter Galloway