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OTTAWA (Reuters) - The Bank of Canada signaled on Tuesday it was closer to raising interest rates as the domestic economy advances despite threatening economic developments in the United States and Europe.
The central bank held its key overnight rate at 1.0 percent, as expected, but said core inflation will reach the bank's 2 percent target earlier than anticipated and that economic growth will speed up in the second half of this year after a second-quarter slump.
In a statement, it removed a reference to monetary stimulus being "eventually withdrawn", used in its May 31 rate statement, suggesting a move was in the not-too-distant future.
"To the extent that the expansion continues and the current material excess supply in the economy is gradually absorbed, some of the considerable monetary policy stimulus currently in place will be withdrawn, consistent with achieving the 2 percent inflation target," the bank said.
Canada became the first of the Group of Seven advanced economies to tighten monetary policy following the global financial crisis, raising rates three times from June to September last year.
The central bank has paused since then, with an eye on threats from abroad such as the weakening U.S. economy and the European sovereign debt crisis, which could slow growth at home.
The bank's comments on Tuesday were more hawkish than markets expected, pushing the Canadian dollar to a 2-1/2 month high against the U.S. dollar.
"There is a vague shift in the tone of the statement, toward slightly more hawkish," said Camilla Sutton, chief currency strategist at Scotia Capital.
"So in terms of what the market will price in, (it) will probably pull forward their expectations for interest rate hikes ever so slightly."
The median forecast of 37 analysts in a July Reuters poll was for a resumption of rate increases in the fourth quarter, which means either at the bank's October 25 or December 6 policy announcement dates.
Some banks were rethinking those forecasts on Tuesday. Scotia Capital, on the dovish end of the forecast spectrum, said it may pull forward its rate hike forecast to this fall from the second quarter of next year.
Overnight index swaps, which trade based on expectations for the key central bank rate, showed investors see an 86 percent probability rates will stay on hold in September, down from 93 percent before the bank's statement.
The swaps market was also betting a bit more on a rate increase this year, although traders still have not priced in a full 25-basis-point hike until 2012.
Bank of Canada Governor Mark Carney has been seen as reluctant to pull the trigger too soon partly out of fear that a wider rate gap with the United States would boost the already-strong Canadian dollar.
As a counterweight to more hawkish language, the bank did flag several caveats to monetary tightening and advised that its projections assume European leaders will be able to contain the sovereign debt crisis.
"A lot of things still have to go right for the bank to be hiking by October, but I still think that's still a reasonable call," said Doug Porter, deputy chief economist at BMO Capital Markets.
The bank maintained its view that the Canadian economy would return to full capacity by the middle of 2012 and that inflation will remain well anchored.
Its growth forecasts were likewise little changed. It shaved its 2011 forecast to 2.8 percent from 2.9 percent and kept its 2012 and 2013 growth forecasts unchanged at 2.6 percent and 2.1 percent, respectively.
The bank said total consumer price index inflation will stay above 3 percent in the near term, largely due to temporary factors. Core inflation is "slightly firmer than anticipated," and "expected to remain around 2 percent over the projection horizon," it said.
Core inflation has been pushed higher partly by temporary factors and partly by higher prices for some services, the bank said.
It said net exports remained weak, reflecting modest U.S. demand and "the persistent strength of the Canadian dollar".
The bank's quarterly Monetary Policy Report, to be released on Wednesday at 10:30 a.m., will break down inflation and growth forecasts on a quarterly basis and include more analysis on the global and domestic outlook.
The Canadian dollar rose as high as C$0.9483 to the U.S. dollar, or $1.0545, up from C$0.9551 to the U.S. dollar just before the rate decision.
Reporting by Louise Egan and Randall Palmer; Editing by Jeffrey Hodgson and Peter Galloway