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OTTAWA (Reuters) - The Bank of Canada said on Tuesday it may need to start raising interest rates, preparing to lead the Group of Seven industrialized nations in lifting borrowing costs even as fears of a flare-up of the European debt crisis have not fully faded.
The central bank held its key overnight rate at 1 percent as anticipated but issued a surprisingly hawkish statement that included explicit language on eventual rate increases for the first time since last July.
"In light of the reduced slack in the economy and firmer underlying inflation, some modest withdrawal of the present considerable monetary policy stimulus may become appropriate, consistent with achieving the 2 percent inflation target over the medium term," the central bank said in a statement.
The language caught traders off guard, with Canadian dollar and rate futures both jumping following the statement.
The central bank described an economy that is at a turning point where inflationary pressures could become a concern and high household debt is the biggest risk.
It raised its growth and inflation forecasts for this year and said the economy will return to full capacity - the limit at which it can grow without generating excessive inflation - in the first half of 2013 rather than in the third quarter as it predicted in January.
The news prompted three of nine primary dealers surveyed by Reuters on Tuesday to pull forward their forecasts for a rate hike.
The median forecast is now for a hike in the first quarter of next year whereas a similar poll last month called for a hike in the third quarter. Five dealers have now pulled forward rate hike forecasts since that poll.
"Certainly it's a more hawkish statement than the market was anticipating," said Sal Guatieri, senior economist at BMO Capital Markets.
"So we could see a rate increase this year - at least a couple of taps on the monetary brakes are possible," he said.
The Bank of Canada has frozen rates since September 2010 after it became the first in the G7 to raise borrowing costs from lows hit during the financial crisis.
It had a false start in mid-2011 when it signaled intentions to increase rates, but it had retreated by September as the European debt crisis exploded.
Its language in Tuesday's statement was more tentative than in July 2011 when the bank said stimulus "will" be withdrawn.
Canada's economy has grown steadily since emerging from the 2008-09 recession but policy makers had warned the recovery was at risk from the European debt crisis.
Those external headwinds have abated somewhat, the bank said on Tuesday, although Spain and Italy have come under market pressure this week in a reminder the crisis is not over.
The outlook, which will be discussed in detail in its quarterly Monetary Policy Report on Wednesday, formalizes the more bullish tone adopted by Bank of Canada Governor Mark Carney in the past month.
"In sum, we view this communiqué as an important, and large, step towards further normalizing the overnight rate," said David Tulk, chief macro strategist at TD Securities.
Such a move would put Canada well ahead of the U.S. Federal Reserve, which has said it expects its key rate to remain near zero until at least late 2014. The European Central Bank likewise has not discussed rate changes, ECB President Mario Draghi said this month.
Tulk now sees the earliest possible date for a hike as September, though he says it is more likely to come later.
On the more hawkish end of the spectrum, Nomura Global Economics analyst Charles St-Arnaud sees a hike as early as the bank's next rate announcement on June 5.
The Canadian dollar strengthened after the release of the bank statement, rising to a near one-month high at C$0.9865 versus the U.S. dollar, or $1.0137, from C$0.9958 to the U.S. dollar, or $1.0042, before the statement.
Overnight index swaps, which trade based on expectations for the central bank's key policy rate, showed that after the statement traders priced in higher odds of a rate hike later this year but see little chance of one at the next meeting in June.
The yield rose on the two-year Canadian government bond, and government bond prices underperformed U.S. Treasuries after the news, especially shorter term issues.
The bank said on Tuesday that economic growth and inflation are both likely to have more momentum than it forecast in its January Monetary Policy Report.
It revised its 2012 growth projection to 2.4 percent from 2 percent in January, but cut its 2013 projection to 2.4 percent from 2.8 percent. It sees growth moderating to 2.2 percent in 2014.
That was more upbeat than the International Monetary Fund's World Economic Outlook, which on Tuesday forecast 2 percent growth this year.
The bank said inflation will soften in the second quarter but then will rise to the bank's 2 percent target "for the balance of the projection horizon". In January it saw inflation reaching 2 percent in the third quarter of 2013.
Editing by Peter Galloway and Jeffrey Hodgson