* Sees growth this quarter
* Says persistent C$ strength could force BoC hand
* Sees risk private demand might be slower than expected
* Bank of Canada still can do more if needed
* Sees Canadian recovery more robust than elsewhere (Adds remarks on Canadian growth being more robust)
By Louise Egan
KINGSTON, Ontario, Aug 25 (Reuters) - Canada's recession most likely ended in the third quarter, the Bank of Canada said on Tuesday, voicing cautious optimism but also warning about the risks of a persistently strong Canadian dollar.
"Two years after the onset of a global financial crisis and after three quarters of severe recession in Canada, the economic outlook for this country, and much of the world, has improved," Deputy Governor Timothy Lane told economists.
"Although the recovery is likely to be muted, and effective and resolute policy implementation will be required, we are likely to experience positive growth this quarter, and a gradual closing of the output gap by the middle of 2011."
But Lane also noted that a good deal of the recovery so far had come from official action, and he said there was a risk that private demand would not emerge as fast as desired.
"At what stage will private demand be robust enough to make the recovery self-sustaining? Clearly, we haven't reached that point yet," he said.
A second important risk, he said, was "the possibility of persistent strength in the Canadian dollar."
"Other things being equal, a persistently strong Canadian dollar would reduce real growth and delay the return of inflation to target," he said.
He said some of the currency's rise had stemmed from factors like higher commodity prices that are leading to a Canadian recovery. Traditionally, the bank has said it would not counter foreign exchange movements based on such factors.
However, he also said it was a result of a more generalized weakening of the U.S. dollar as global financial conditions normalize.
The Canadian unit further weakened after Lane's remarks were published, extending a slide against the U.S. currency that partly reflected strong U.S. economic data that boosted the greenback.
"I suppose the market is looking at two things. One is no suggestion that rate hikes are forthcoming sooner than previously thought, and two, the trepidation the Bank of Canada is expressing over Canadian dollar strength," said Eric Lascelles, chief economics and rates strategist at TD Securities.
If the stronger dollar were to alter the path of projected inflation, the central bank would need to take that into account, he said, noting that it retained considerable monetary policy flexibility, including possible quantitative easing.
Quantitative easing refers effectively to the printing of money, the kind of unconventional instrument which could be required since the bank cannot cut its target interest rate below its current floor of 1/4 percent.
Lane noted that the bank's conditional commitment to keep rates at that level until mid-2010 had helped.
He said Canada's recovery would be supported by factors which would make it "somewhat more robust" than elsewhere.
First, recovery in hard-hit U.S. sectors like housing and cars will benefit Canadian exporters. Second, Canada's financial system is functioning well. Third is the underlying strength of household, business and government balance sheets. (Writing by Randall Palmer; editing by Janet Guttsman and Frank McGurty)