UPDATE 1-Iceland c.bank holds fire, eyes higher rates

* Iceland c.bank keeps rates unchanged

* Eyes hikes in the near future

(Adds quotes, details)

STOCKHOLM, Oct 3 (Reuters) - Iceland's central bank kept interest rates unchanged at 5.75 percent on Wednesday and said it expected to have to tighten policy in the near future as its economy recovers.

"As spare capacity disappears from the economy, it is necessary that monetary policy slack should disappear as well," the Reykjavik-based bank said in a statement.

The bank said in its statement after keeping rates unchanged that recent indicators suggested a slower recovery of domestic demand than was forecast in August. But it said risks to the economy from the financial crisis in Europe had abated.

It said the pace of policy tightening would depend on inflation.

" ... but in the absence of changes in the outlook for inflation and the economic recovery, it is likely that further interest rate increases will be needed in the near future," it said.

The country with a population of just 320,000 has faced inflation pressures stemming from a weakening currency after its banking sector collapsed during the financial crisis that began in 2008, which also forced it to seek billions of dollars in bailout loans from the International Monetary Fund and others.

The Icelandic krona is still not freely traded and the country still has capital controls in place to prevent excessive outflows. Interest rates are expected to remain high as it gradually removes those controls.

Central bank governor Mar Gudmundsson said recently that he expected rates were more likely to rise than fall in the future.

"On balance, the inflation outlook has not changed significantly since the MPC's (monetary policy committee) last meeting (in August). Inflation expectations remain above the Bank's inflation target, although they have declined slightly by some measures," it added.

(Reporting by Patrick Lannin and Simon Johnson; editing by Patrick Graham)

((Stockholm Newsroom, tel: +46-8-700 1017, e-mail: stockholm.newsroom@thomsonreuters.com))