UPDATE 1-Bank of Canada leaves door open to rate cut if risks grow

Wednesday, 22 Jan 2014 | 10:25 AM ET

* Bank of Canada holds key rate at 1.0 pct as expected

Says risk of low inflation has become more severe

* Says direction of next rate move depends on data

* Sees weaker C$ boosting exports, investment

By Louise Egan and Randall Palmer

OTTAWA, Jan 22 (Reuters) - The Bank of Canada signaled on Wednesday it is more concerned about weak inflation than it was three months ago and explicitly stated that its next move on interest rates could be either down or up, depending on how economic data unfolds.

The bank held its main overnight rate unchanged at 1.0 percent, as expected. While it said a more firmly entrenched U.S. recovery and a weaker Canadian dollar would help lift exports this year, its guidance on monetary policy was incrementally more dovish than it had been.

"Although the fundamental drivers of growth and future inflation appear to be strengthening, inflation is expected to remain well below target for some time and therefore the downside risks to inflation have grown in importance," it said.

"The timing and direction of the next change to the policy rate will depend on how the new information influences the balance of risks," it added, acknowledging the possibility of easing monetary policy.

Governor Stephen Poloz had said in an earlier news conference that the bank's stance was neutral and that this meant that rates could fall as easily as rise, but such language has not been put into the bank's official rate statement until now.

The bank omitted a phrase it used in its last two rate announcements that said "the substantial monetary policy stimulus currently in place remains appropriate".

The Canadian dollar fell to a four-year low of C$1.1039 to the greenback, or 90.59 U.S. cents, after the bank's statement, down from Tuesday's close of C$1.0972, or 91.14 U.S. cents.

In a Reuters poll last week, analysts predicted the bank's next move would be a rate hike but not until the second quarter of 2015. Although none of the 37 analysts surveyed actually forecast a rate cut, many bet correctly that the bank would sound a bit more dovish in its statement on Wednesday.

The central bank, led by Poloz since June, dropped a longstanding bias towards hiking interest rates last October. It has not changed its key rate since September 2010.

The bank's increased concern about possible disinflation is shared by policymakers around the world and comes at a time when global markets are highly sensitive to interest rate risk.

The U.S. Federal Reserve has begun scaling back its massive stimulus program and there is talk about the Bank of England possibly raising rates. On the other hand, the European Central Bank and Bank of Japan are firmly in stimulus mode.

The bank sees inflation lower than it had forecast in its last quarterly report in October, with total and core measures around 1 percent in the first half of 2014, at the bottom end of its target range of 1 to 3 percent. But it still sees the inflation rate returning to the 2 percent target in "about two years".

Canadian economic growth sped up in the latter half of 2013, absorbing a little more spare capacity, it said, but it warned there was no sign so far that exports and business investment were replacing indebted consumers as the drivers of growth.

The bank said, however, it is hopeful the sources of growth will broaden. It sees net exports contributing to annual growth in 2014 after being flat or detracting from growth since 2009.

Stronger foreign demand will also prompt businesses to invest more, it said, while consumer spending will be moderate and housing investment relatively unchanged.

The recent depreciation of the Canadian dollar will help in that process, the bank said, as well as exert some upward pressure on inflation.

The Canadian dollar has fallen by more than 6 percent against the U.S. dollar since the bank's October policy shift.

"This depreciation likely reflects the improved growth prospects in the United States, as well as reduced safe-haven effects that had pushed the Canadian dollar higher in the aftermath of the global financial crisis," the bank said.

However, it said the dollar "remained strong" and would continue to pose challenges for noncommodity exports.

The bank raised its forecast of 2014 growth to 2.5 percent from 2.3 percent, following anticipated growth of 1.8 percent in 2013.