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UPDATE 3-Bank of Canada holds rates steady, sees economy in 'sweet spot'

(Recasts; adds comment from Poloz, economists)

OTTAWA, Oct 25 (Reuters) - The Bank of Canada held interest rates steady on Wednesday, as expected, even as it said the economy was at or near full capacity, signaling it was willing to let the economy run a little bit hot amid uncertainty over NAFTA renegotiations.

Bank of Canada Governor Stephen Poloz said he believed the economy was in a "sweet spot," generating more growth than expected but less inflation - a dovish turn for the central bank after back-to-back rate hikes in July and September.

While Poloz said more rate hikes will be required over time, he noted the bank will be cautious as it considers its next move, watching how the economy adjusts to higher interest rates, tighter mortgage rules and uncertainty about U.S. trade policy.

The wait-and-see message sliced more than a cent from the Canadian dollar, which tumbled to its weakest point since July, and bets on a December rate increase slipped to less than 30 percent from 37 percent before the rate announcement.

While analysts bumped their expectations for the next rate hike into 2018, Desjardins' senior economist Jimmy Jean said the bank's faith in a "Goldilocks economy" means it could find itself behind the curve if inflation rears its head.

"The risks would be that it underestimates the potential for higher inflation and lets upward inflationary pressures build unaddressed - and is forced to eventually respond with more aggressive rate hikes than otherwise," Jean said.

National Bank Financial chief economist Stefane Marion said inflation could also bubble up more quickly than the bank expects, particularly given minimum wage increases set to come into effect in the province of Ontario.

"He's clearly unwinding the expectations for short-term rate hikes," said Marion. "It's fine if you're right with your forecast, but it can be very unpredictable at this point in time. I would have given myself a little bit more elbow room."

Still, Poloz pointed to slack in the labor market as evidence that there could be more room for growth without spurring price rises, and said policymakers are "more preoccupied with the downside risks to inflation."

The bank said recent mortgage rule tightening would dampen Canada's once red-hot housing market further, and warned that a drop in house prices in Toronto or Vancouver could douse residential investment and consumption in those areas and have "modest direct spillovers" to the rest of Canada. (Additional reporting by Fergal Smith in Toronto; editing by G Crosse)