OTTAWA (Reuters) - The Bank of Canada raised its benchmark interest rate to 3.50 percent from 3.25 percent on Tuesday and said "some modest further increase" lay ahead.

"In line with the bank's base-case projection and current assessment of risks, some modest further increase in the policy interest rate would be required to keep aggregate supply and demand in balance and inflation on target over the medium term," the bank's statement said.

It was the bank's fourth quarter-point increase in a row since September and contrasts with December's statement which called for "some further reduction in monetary stimulus."

The Canadian dollar fell on the news to C$1.1573 against the U.S. dollar, or 86.41 U.S. cents, compared with C$1.1536, or 86.69 U.S. cents, about an hour before the announcement.

Adding to the currency's fluctuations was the fallout from Monday's election, when Canadians voted in a minority Conservative government to replace the minority Liberal one.

The central bank said inflation was lower than expected at 2.3 percent, due to lower gasoline prices but both it and core inflation, holding at a "stable" 1.6 percent, should converge at the mid-point of the bank's 1-3 percent target range by the first half of 2007.

An overview of the economy is due in Thursday's Monetary Policy Report Update. The next rate decision is due March 7.

"They said nothing's changed in their view of the economy so markets focused on the word 'modest' to mean they'll be less aggressive," TD Securities chief fixed income strategist Marc Levesque said.

"I think they want to avoid a debate on what is neutral," he said. "I wouldn't conclude they're more dovish. We'll know on Thursday."

The bank reiterated that the Canadian economy is running at full production capacity and is adjusting to global developments and associated changes in relative prices.

Risks to the bank's projection remain balanced for 2006 but are tilted to the downside through 2007 and beyond.

"The only debate now is whether that means 25 or 75 basis points (increase) from here. I think how the data roll in over the next few months will go a long way in determining that," BMO Nesbitt Burns deputy chief economist Doug Porter said.

"I don't think the bank has set anything in stone, but it does sound like they've put a ceiling on the rate hikes."

The bank's statement said its outlook for growth and inflation in Canada was similar to its projection in October, and the Canadian economy, at full production capacity, will continue to grow through 2007.

Beneath the surface of steady growth, however, is a schism in the Canadian economy with oil-producing provinces growing at blistering rates while the industrial heartland in Ontario and Quebec have shed about 100,000 jobs in the past 12 months.