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OTTAWA (Reuters) - The Bank of Canada laid the groundwork to hike interest rates later this year by raising its 2011 growth and inflation forecasts on Tuesday even as it held policy steady and used less hawkish language than markets expected.
The central bank, as was widely forecast, held its key overnight rate target at 1 percent, but its accompanying statement knocked down the Canadian dollar and lowered market expectations that it would lift rates in May.
The Canadian economy will return to capacity six months earlier than previously expected, by mid-2012, the bank said. Likewise, it shortened the timeline for inflation to hit its 2 percent target, adding the rate would spike to 3 percent in the second quarter of this year.
But it made no signal it was likely to lift borrowing costs at its next decision date on May 31, saying that any such move would "need to be carefully considered" in a repeat of a phrase it has used for the past several months.
In unusually strong language on the currency, it warned that the strong Canadian dollar continued to be a nuisance, hampering the export recovery and depressing prices.
"The persistent strength of the Canadian dollar could create even greater headwinds for the Canadian economy, putting additional downward pressure on inflation through weaker-than-expected net exports and larger declines in import prices," the bank said.
As if to prove the point, Statistics Canada on Tuesday reported a disappointing trade performance in February, with exports falling 4.9 percent and the trade surplus declining to a negligible C$33 million ($34 million).
All in all, the bank took pains to continue sitting on the fence, while keeping alive expectations of a July rate hike.
"There's nothing here to really suggest that the Bank of Canada wants to take interest rates higher at the May meeting. But certainly there's this idea that a July move is in play," said David Tulk, chief Canada macro strategist at TD Securities.
The Canadian dollar, which on Monday closed near a 3-1/2 year high against the U.S. dollar, weakened to C$0.9608 to the U.S. dollar, or $1.0408, compared with C$0.9569 just before the announcement.
Overnight index swaps, which trade based on expectations for the key central bank rate, showed investors see a 8.41 percent chance of a rate hike in May, down from 26.61 percent before the bank's Tuesday statement. They were also pricing in a lower probability of rate hikes for all subsequent 2011 decision dates.
Unlike some other major economies, Canada has been relatively immune to inflationary pressures from rising food and energy costs. Core inflation hit its lowest level since 1985 in February, while the overall annual inflation rate was a tame 2.2 percent.
That has allowed the bank to keep its key rate on hold since last September, following three consecutive increases which made it the first central bank in the G7 to tighten policy following the global financial crisis.
Growth began to heat up in the fourth quarter and early 2011, forcing the bank to raise its economic growth forecast for this year to 2.9 percent from 2.4 percent. However, it cut the outlook for next year to 2.6 percent from 2.8 percent and sees 2013 growth in line with potential growth at 2.1 percent.
Fear of driving the Canadian dollar, known as the loonie, to new heights may be motivating the central bank to be more guarded than usual about its rate intentions, some analysts said. If markets think an increase is coming, it could trigger a rally in the currency beyond Monday's 3-1/2 year high.
"I think their worry is that they run the risk of extrapolative expectation, so that they move once and markets say, 'well that's just once in a series of tightening' and they get there too fast, rates move higher and the currency overshoots," said Craig Wright, chief economist at RBC.
"It's going to be a cautious process toward normalizing rates and it's going to take a couple of years rather than a couple of quarters," he told Reuters in Calgary.
With additional reporting by Scott Haggett, Chandra Ramarathnam, Claire Sibonney, Ka Yan Ng and Solarina Ho; Editing by Jeffrey Hodgson and Peter Galloway