* Inflation rate near central bank target
* Gasoline drives CPI higher due to base effects
* Bank of Canada not likely alarmed by inflation data
* Foreigners invest heavily in Canadian bonds
By Louise Egan
OTTAWA, Feb 18 (Reuters) - Higher gasoline prices pushed Canada's annual inflation rate to near the central bank's 2 percent target in January, but no reaction is expected from the bank which is holding interest rates at historic lows.
The consumer price index climbed 0.3 percent in the month, Statistics Canada said on Thursday. But 12-month inflation sped past expectations to 1.9 percent from 1.3 percent in December as prices in the transportation sector rose by the largest amount since September 2005.
The strong kick-off to 2010 sparked a rally in the Canadian dollar to as high as C$1.0434, or 95.84 U.S. cents, from C$1.0465, or 95.56 U.S. cents, just before the data.
Analysts had expected inflation at a slightly lower 1.8 percent but still approaching the Bank of Canada's target at the midpoint of a 1-3 percent range.
But they warned against bets that the central bank would react by lifting its benchmark interest rate from a rock-bottom 0.25 percent, saying the strong inflation number reflects the base effects of low fuel prices a year earlier, which could fall out of the equation by mid-2010.
"The minute we touch this (2 percent) number, the bond market gets nervous, so I will expect the bond market to react negatively to this number," said Benjamin Tal, senior economist at CIBC World Markets.
"However we have to remember that those numbers reflect not month-over-month change, but rather a year-over-year comparison, which can be misleading given the fact that last year was a relatively weak number," he said.
Yields on overnight index swaps, which trade based on
expectations for the key central bank rate, edged higher after
the inflation data, suggesting the market saw tightening as
slightly more likely. The pricing shows investors expect the
rate will be around 0.50 percent in July and 0.75 percent in
October.
A separate Statscan report showed foreign investors were lured into Canada's bond market in a big way in December and throughout 2009. Non-residents bought an unprecedented C$109.37 billion ($105.16 billion) in Canadian securities in the year. [ID: SCLIDE613]
"Canada continued to represent one of a handful of developed world economies that wasn't facing some scrutiny over its fiscal profile or concern for potential negative ratings events," said Stewart Hall, markets strategist at HSBC Canada.
INFLATION NO REASON FOR ALARM
Rising vehicle prices pressured the core rate of inflation, which strips out gasoline and other volatile items to reflect underlying price trends, to 2 percent annually, after edging up 0.1 percent in the month. Vehicle prices had been exerting downward pressure on core CPI for much of 2009.
The Bank of Canada has pledged to hold its benchmark interest rate at the current level until the end of June as long as inflation does not spin out of control.
"I think it's far from a situation where the Bank of Canada is going to be getting alarmed," said David Watt, senior currency strategist at RBC Capital.
"The Bank of Canada still sees a lot of slack in the economy, especially on the goods producing and manufacturing side ... Pricing pressures don't really seem to be developing all that strongly. The unemployment rate is still elevated relative to where they would probably get concerned about inflationary pressure building," he said.
The bank's latest forecast is for 12-month CPI to average 1.6 percent in the first quarter of this year, and for 12-month CPI on both an overall and core basis to reach 2 percent in the third quarter of 2011. (Additional reporting by Scott Anderson and Ka Yan Ng in Toronto; editing by Rob Wilson)