By Louise Egan and Randall Palmer
OTTAWA (Reuters) - The Bank of Canada held its overnight interest rate steady on Wednesday, but sounded a touch more dovish in its outlook, saying the risks of undesirably weak inflation appeared greater than they did six weeks ago.
The change in tone knocked the Canadian dollar to its weakest level in three years. Traders slightly increased bets on the possibility of a rate cut in late 2014, though they are still pricing in less than a 25 percent chance of this happening.
The central bank stunned markets in October by abandoning 18 months of signaling that rate hikes were on the horizon. But it made clear at the time it was just as likely to raise rates as to lower them as it was caught between excessive household debt on one hand and below-target inflation on the other.
The bank's statement on Wednesday showed it was now increasingly concerned about possible disinflation after the inflation rate dropped to 0.7 percent in October. It added, however, that the balance of risks remained within the range of possible scenarios it had identified in October.
"The risks associated with elevated household imbalances have not materially changed, while the downside risks to inflation appear to be greater," it said.
Royal Bank of Canada Assistant Chief Economist Paul Ferley said the surprising emphasis on the downside risks to inflation would weigh on the Canadian dollar.
"I thought there would be a bit more balance in terms of indications of growth coming in stronger than expected," he said, adding that Royal still sees the central bank holding rates steady through 2014.
The Canadian dollar weakened after the statement to C$1.0695 to the U.S. dollar by 10:51 a.m. EST (1551 GMT) from C$1.0662 just before the statement.
The bank has kept its overnight rate target at 1 percent since September 2010, following three successive hikes that year as Canada pulled out of a relatively mild recession.
None of 32 analysts polled by Reuters last week had expected any rate move on Wednesday, but many market players were nonetheless bracing for the possibility that the bank would somehow introduce more dovish language without signaling actual rate cuts.
The median forecast in that poll was for the bank to start raising rates in the second quarter of 2015.
Overnight index swaps on Wednesday, which trade based on expectations for the policy rate, showed traders pricing in a small chance of a cut next year rather than a hike.
But Scotiabank Chief Currency Strategist Camilla Sutton said concerns about Canadians' indebtedness, caused largely by housing purchases, would probably prevent lower rates.
"It's unlikely the Bank of Canada would be able to cut rates when they have household debt as high or financial stability risk as high as it is," she said.
Wednesday's policy statement said the housing sector had been stronger than expected, but this was consistent with demographics and with people pulling forward their home purchases because of low rates.
"The bank continues to expect a soft landing in the housing market," the statement said.
The Bank of Canada targets 2 percent inflation, within a range of 1 to 3 percent. The rate has been below 2 percent since May 2012.
The bank's statement on Wednesday said sluggish core inflation was caused by significant excess supply in the economy and fierce competition in the retail sector, which it said was more persistent than it had anticipated. Overall inflation has been pushed down by gasoline price cuts.
The bank's growth outlook was little changed and it maintained its projection that the economy would return to full capacity around the end of 2015.
While housing was stronger than expected, exports and business investment have continued to disappoint. Exporters have struggled with soft U.S. demand and a Canadian currency still much stronger than it was a decade ago.
The Bank of Canada targets inflation rather than the exchange rate, but does monitor how the currency affects prices and economic growth.
"The one thing the bank does say is they are still disappointed in the fact that exports aren't picking up. So I think if you read between the lines, they do have their eye on the Canadian dollar and would be perfectly happy go see it at a lower (weaker) level," said BMO Capital Markets Senior Economist Robert Kavcic.
(Editing by Peter Galloway, Jeffrey Hodgson and Leslie Gevirtz)