(Corrects third paragraph to show economy seen back at capacity by mid-2012, not mid-2010)
* BoC statement slightly less hawkish than some expected
* Raises 2011 growth forecast, cuts 2012
* Uses strong language on C$ strength
* Sees inflation hitting target 6 months early
* Markets slightly reduce rate hike expectations (Adds details, market activity, background)
By Louise Egan
OTTAWA, April 12 (Reuters) - The Bank of Canada laid the groundwork to hike interest rates later this year by raising 2011 growth and inflation forecasts on Tuesday even as it held rates steady and used less hawkish language than markets expected.
The central bank, as was widely forecast, held its key overnight target at 1 percent.
The Canadian economy will return to capacity six months earlier than previously expected, by mid-2012, it said in its closely watched statement. Likewise, it shortened the timeline for inflation to hit its 2 percent target by the same amount, adding the rate would spike to 3 percent in the second quarter of this year.
But it made no signal it was likely to lift borrowing costs at its next decision date on May 31, saying any such move would "need to be carefully considered" in a repeat of a phrase used for the past several months.
In unusually strong language on the currency, it warned that the strong Canadian dollar continued to be a nuisance, hampering the export recovery and depressing prices.
"The persistent strength of the Canadian dollar could create even greater headwinds for the Canadian economy, putting additional downward pressure on inflation through weaker-than-expected net exports and larger declines in import prices," the bank said.
All in all, the bank took pains to continue sitting on the fence while keeping alive market expectations of a July rate hike.
"There's nothing here to really suggest that the Bank of Canada wants to take interest rates higher at the May meeting. But certainly there's this idea that a July move is in play," said David Tulk, chief Canada macro strategist at TD Securities.
The Canadian dollar
Overnight index swaps, which trade based on expectations
for the key central bank rate, showed investors see a 8.41
percent chance of a rate hike at the next meeting, down from
26.61 percent before the statement. They were also pricing in a
lower probability of rate hikes for all subsequent 2011
decision dates.
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Graphic on Bank of Canada rates, inflation: http://r.reuters.com/vad98r
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The bank warned higher energy prices and tax changes in Canada would cause a short-term spike in inflation to 3 percent in the second quarter of this year.
The Canadian dollar, which finished on Monday near a 3-1/2 year high against the U.S. dollar, has generally helped curb inflation and give the bank more breathing room to keep rates low.
Inflation pressures eased in February as the core rate, which excludes gasoline and other volatile items, slipped to 0.9 percent year-on-year, the lowest since at least 1985. The overall inflation rate was 2.2 percent annually.
The bank raised its economic growth forecast for this year to 2.9 percent from 2.4 percent, but cut its estimate for next year to 2.6 percent from 2.8 percent. It said the overall growth profile was largely the same as it had anticipated in January.
"They acknowledge that growth has been stronger than expected, no surprise there. But they continue to cite the serious challenges that the economy faces, and there's really no significant change in the core inflation outlook," said Doug Porter, deputy chief economist at BMO Capital Markets.
The central bank became the first in the G7 advanced economies last year to tighten monetary policy following the global financial crisis, raising its rates three times from July-September but pausing since then due to the weak global recovery. (With additional reporting by Chandra Ramarathnam, Claire Sibonney, Ka Yan Ng and Solarina Ho; Editing by Jeffrey Hodgson)