* Recession over but economy faces challenges
* Assumes C$ at 96 U.S. cents, around current levels
* Says C$ is the major downside risk to its projection
* Markets should not underestimate bank's determination (New with Carney news conference)
By Randall Palmer
OTTAWA, Oct 22 (Reuters) - The Canadian economy is recovering faster than expected, but it faces a number of risks, including a weak U.S. economy and a Canadian dollar that seems set to stay strong, the Bank of Canada said on Thursday.
In a quarterly economic projection that included a sharply higher assumption for the Canadian currency, the central bank singled out the Canadian dollar as the biggest single risk to an economy that has just started emerging from recession.
"Look, it's a risk. It's more than offset the positive developments that have happened since July, which have been considerable," Bank of Canada Governor Mark Carney told a news conference. "It is the major downside risk -- continuing persistence of the dollar."
Carney warned the central bank would use whatever tools it needed if the currency's drag on the economy threatened to keep it from returning the inflation rate to its 2 percent target.
Foreign exchange intervention -- selling Canadian dollars on the forex market to drive the currency lower -- was "always an option," he added. The Canadian dollar briefly spiked lower following the comments.
"Markets should take seriously our determination to set policy to achieve the inflation target. Markets sometimes lose their focus. We don't lose our focus," he added.
The central bank's Monetary Policy Report assumed a
Canadian currency
That is much higher than the 87 U.S. cents (C$1.1494 per U.S. dollar) it assumed in July, and a level that will make it harder for Canadian companies to compete abroad.
The Bank of Canada forecast growth of 2.0 percent in the third quarter and 3.3 percent in the final quarter of the year, up from 1.3 percent and 3.0 percent in its July projections.
It said risks were high, but had diminished from those in previous months.
"Following three consecutive quarters of sharp contraction, economic growth has resumed in Canada," it said.
The central bank said the labor market may have stopped deteriorating, financial conditions were improving and consumer spending is expected to grow solidly through 2011. Business fixed investment should recover in early 2010.
The bank has promised to keep the overnight rate at 0.25 percent through mid-2010, provided inflation remained on track, and Carney said this pledge remained appropriate. Rates could hold steady beyond next June, he added.
The Canadian economy had "a tremendous amount of slack" after three quarters of very sharp recession, he said.
The bank signaled that the currency's rise was not simply due to strength in commodity markets, which traditionally benefits Canada's export-oriented economy.
"While higher commodity prices have been supportive, movements in the Canadian dollar over the period appear to have been increasingly driven by a broader depreciation of the U.S. dollar against major currencies," it said.
It said that one risk to its overall outlook was that the dollar would rise even higher than the assumed 96 U.S. cents as investors sell U.S.-dollar assets.
The Canadian dollar climbed above its American counterpart in late 2007 without triggering the doomsday scenarios that exporters grumbled about at the time. But Carney warned against downplaying the challenge this time around.
"Things have changed since the last time we were at these levels," he said, noting that the outlook for the United States was much worse and the structure of global growth had shifted. (Editing by Janet Guttsman and Jeffrey Hodgson)