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UPDATE 3-Bank of Canada surprises with more rate-hike talk

* BoC softens hawkish language slightly

* Timing of rate hike now less definite

* Bank says will consider household debt in setting policy

* Inflation, growth outlook slightly more downbeat

OTTAWA, Oct 23 (Reuters) - The Bank of Canada surprised markets on Tuesday by leaning towards higher interest rates and issuing a fairly upbeat outlook on growth, adding for the first time that soaring household debt could justify eventual rate increases.

The central bank, which has held its key rate at 1.0 percent for two years, continued to use the hawkish language adopted in April that has made it an outlier among the central banks of major economies.

It softened its tone only slightly by making the timetable for rate hikes less definite.

``All in all, the Bank of Canada continues to be one of the most hawkish central banks in the advanced economies,'' said Camilla Sutton, chief currency strategist at Scotiabank.

Canada recovered more quickly from the global financial crisis than the United States or Europe and continues to grow moderately with a relatively small budget deficit to deal with.

Markets had been primed for milder language after a speech by Bank of Canada Governor Mark Carney last week that was seen as decidedly more dovish.

But Carney largely held his ground, even as the U.S. Federal Reserve kicks off a two-day meeting, which is expected to assess a major new bond-buying plan announced last month and as the Bank of Japan is widely seen providing more support for its economy.

Previously, the Bank of Canada had made rate hikes conditional on the economy absorbing excess slack, a way of saying gross domestic product would have to expand by at least 2 percent, a scenario which is seen as increasingly unlikely as growth slows.

That reference was dropped on Tuesday.

``Over time, some modest withdrawal of monetary policy stimulus will likely be required, consistent with achieving the 2 percent inflation target,'' the bank said in its statement.

The bank appeared intent on telegraphing that rates will go up, not down, even in the face of global uncertainty.

``We thought they'd water it down a bit. But from some angles, this actually isn't watered down much at all,'' said Doug Porter, deputy chief economist at BMO Capital Markets.

The Canadian dollar firmed against the U.S. currency after the rate statement but later retreated to the same level as Monday's close at C$0.9926 versus the U.S. dollar, or $1.0075.

Short-term debt prices fell on the news. The two-year government bond lost 8 Canadian cents to yield 1.136 percent, even as the benchmark 10-year bond rose 18 Canadian cents to yield 1.853 percent.

Overnight index swaps, which trade based on expectations for the central bank's key policy rate, showed that after the announcement traders made fresh bets on the possibility of a rate hike in 2013.

Analysts in a Reuters poll last week forecast the bank would wait until the fourth quarter of next year before raising rates.

DEBT BURDEN IN DANGER ZONE

Flagging its alarm over Canadian consumers piling on more debt than they can afford, the bank said for the first time that the state of personal finances would help decide the timing of rate hikes, as part of the bank's assessment of conditions.

``Households need to slow their borrowing on their own, or else the Bank of Canada will give them a reason to do so,'' Avery Shenfeld, chief economist at CIBC World Markets, said in a note to clients.

The debt-to-income ratio of Canadian households has climbed to levels seen in the United States before its housing crash. For every dollar earned, households owe C$1.64 - the highest ratio on record.

Mortgages explain much of that debt as Canadians take advantage of ultra-low borrowing costs at a time of rising home prices. But the hot housing market that had persisted since the 2008-09 recession has begun to slow after the government tightened mortgage rules for the fourth time since 2008.

``That might be just enough to keep Carney's new weapon - rate hikes aimed at debt levels - sitting on the shelf for next year. But those who expect that the Bank would make that pledge today, or even more dramatic, think about scenarios for rate cuts, got a bit of a rude awakening,'' said Shenfeld.

The Bank of Canada said it expects housing activity to decline, but sees the household debt burden rising further before stabilizing by the end of 2014.

Its growth and inflation outlook for Canada were tweaked slightly and a little more downbeat than in July. It now sees the economy returning to full capacity and inflation returning to its 2 percent target by the end of 2013.

The bank sees economic growth this year of 2.2 percent and growth of 2.3 percent and 2.4 percent in 2013 and 2014, respectively.