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OTTAWA (Reuters) - The Bank of Canada raised its key interest rate on Tuesday, as expected, but warned the domestic and global recovery will be slower than it had previously forecast, suggesting any further hikes may be gradual.
The central bank became the first in the Group of Seven advanced economies last month to raise rates from the emergency lows introduced during the global financial crisis. It took a second step on Tuesday, lifting the rate 25 basis points to 0.75 percent.
Canada's blistering growth rate and job gains had led to widespread expectations of another rate hike, putting the Bank of Canada leagues ahead of the U.S. Federal Reserve and other G7 central banks, which are not yet ready to end the era of easy money.
But the hawkish stance on rates contrasted sharply with the dovish outlook in the accompanying statement, leaving markets in suspense about the bank's next move. It shaved its growth forecast for the Canadian economy this year to 3.5 percent from 3.7 percent and said Europe's bid to wrestle down sovereign debt would pinch the pace of the global rebound.
"Given the considerable uncertainty surrounding the outlook, any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments," the bank said in its announcement.
The lack of guidance on rates was identical to language used in its June 1 rate hike announcement.
In a Reuters poll conducted after the rate announcement, all 12 of Canada's primary securities dealers predicted another quarter-point increase on September 8 but most expected a pause in the tightening cycle in either October or December.
That puts Canada in the same basket as other commodity exporters such as Brazil, which is seen raising interest rates on Wednesday but pausing soon on signs that strong growth is cooling.
"This is consistent with a very, very gradual removal of policy stimulus," said Sheryl King, chief Canadian economist at Bank of America Merrill Lynch.
Bank of Canada Governor Mark Carney likely feels compelled to push up rates to levels that are more in sync with an economy that is churning out jobs at an impressive rate, said Sal Guatieri, senior economist at BMO Capital Markets.
But he also aims to prevent markets from premature tightening and may be reluctant to get too much of a head start on the Fed for fear of sparking a rapid appreciation of the Canadian dollar, which could hamper the export recovery.
"I suspect that this will probably be the longest lag in history between an increase in rates in Canada and no policy response in the U.S.," said Yanick Desnoyers, an economist at National Bank Financial.
Yields on overnight index swaps, which trade based on expectations for the central bank's policy rate, now suggest there is a 37 percent chance of a 25 basis point increase on September 8, up from 30.1 percent earlier on Tuesday.
The Canadian dollar softened against the U.S. dollar immediately after the rate announcement to C$1.0574, or 94.57 U.S. cents, compared with Monday's finish of C$1.0549, or 94.80 U.S. cents. It later recovered.
Short-term money market rates rose, but bond yields mostly fell.
The bank cut its growth outlook for next year to 2.9 percent from 3.1 percent, more in line with market forecasts, but raised its 2012 forecast to 2.2 percent from 1.9 percent.
The bank now sees the economy returning to full capacity by the end of 2011, two quarters later than it estimated in its April Monetary Policy Report.
The biggest threat to Canada, economists said, comes from a loss of momentum in the United States, by far Canada's largest trading partner.
"Since it's now the U.S. instead of Europe, as was the case during the spring, of course the impact for the Canadian economy will be higher," said Benoit Durochers of Desjardins Securities.
On the domestic front, business investment has not bounced back after shrinking during the recession, the bank said. But inflation is behaving as anticipated and should remain near the bank's 2 percent target through the end of 2012.
The bank will provide more detailed forecasts, and the assumptions underlying them, in its quarterly Monetary Policy Report on Thursday.
Additional reporting by John McCrank, Jennifer Kwan, Claire Sibonney and Euan Rocha in Toronto; Editing by Jeffrey Hodgson and Rob Wilson