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UPDATE 2-Bank of Canada leaves door open to rate cut; C$ sinks

Louise Egan and Randall Palmer
Wednesday, 22 Jan 2014 | 11:37 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

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 said a "strong" currency is still hampering the country's exports, helping send the Canadian dollar to a four-year low.

The central bank held its main interest rate at 1.0 percent, as expected, and explicitly stated that its next move on interest rates could be either down or up, depending on how economic data unfolds.

"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," the bank said in a statement.

"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 a previous news conference that the bank's stance was neutral and that this meant that rates could fall as easily as rise, but such language had 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".

"It's probably as dovish as they could go without adopting an outright easing bias," said David Tulk, chief macro strategist for Canada at TD Securities.

"Definitely there is scope, I think, if the data does disappoint, for them to introduce an easing bias in the future, he said, emphasizing that an actual rate cut would only come if the inflation and other data deteriorate.

The bank was also surprisingly frank about the positive impact of the Canadian dollar's recent depreciation on exports and economic growth as the U.S. recovery becomes more firmly entrenched. The currency's drop will also help drive inflation upward, it said.

Still, the bank said the Canadian dollar remains "strong" and that its strength remains an obstacle for some exports, remarks that were seen by some as a thumbs up to further weakening of the currency.

"That is about as direct a statement as the bank has made in quite some time on the level of the currency and its impact," said Doug Porter, chief economist at BMO Capital Markets.

"And so without becoming even more dovish they have found a way to signal to the markets that they wouldn't mind an even weaker currency."

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

The Canadian dollar has fallen by more than 6 percent against the greenback since the October policy shift.

It dropped to a four-year low of C$1.1039 to the greenback, or 90.59 U.S. cents, after the bank's statement on Wednesday , down from Tuesday's close of C$1.0972, or 91.14 U.S. cents. It later regained some ground.

In a Reuters poll last week, analysts predicted the bank's next rate move would be a 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.

GLOBAL DISINFLATION WORRIES

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 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, 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 remained hopeful, however, that net exports would contribute to growth in 2014 after being flat or detracting from growth since 2009. Stronger foreign demand will also prompt more business investment, it said, while consumer spending will be moderate and housing investment relatively unchanged.

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