OTTAWA (Reuters) - The Bank of Canada held its key overnight interest rate steady on Tuesday, as expected, and gave no sign it was considering further hikes, flagging instead the dampening effect on the economy of the strong Canadian dollar.

In a statement seen as surprisingly dovish, the bank said its outlook for inflation and growth remained "largely unchanged" from forecasts it made in April despite recent reports showing higher-than-expected inflation and gross domestic product growth.

"In line with the bank's largely unchanged outlook, the current level of the target for the overnight rate is judged at this time to be consistent with achieving the inflation target over the medium term," the bank said in its statement.

The Canadian dollar fell on the news, dropping to C$1.1320 to the U.S. dollar, or 88.34 U.S. cents, from around C$1.1245, or 88.93 U.S. cents, just before the decision. Bond prices rose across the board.

While pointing to surprisingly strong economic growth in the first half of 2006, the bank cautioned that the pace of growth would falter more than expected in 2007 and 2008 due to the drag on net exports from the sharp appreciation of the Canadian dollar.

In its April monetary policy report, the bank had forecast GDP growth of 3.1 percent in 2006, 3.0 percent in 2007 and 2.9 percent in 2008.

"The market was expecting there to be at least some indication that the bank was contemplating another rate hike in September, even if it paused now, and there's nothing of the sort," said Marc Levesque, chief strategist at TD Securities.

Most securities dealers surveyed by Reuters had expected the central bank to pause after raising rates seven times since last September, though some had predicted a more hawkish tone in Tuesday's statement. Half of the 14 dealers projected a rate hike at the bank's September 6 policy announcement.

OUTLOOK WEAKER

As in May, when it last hiked rates, the bank made no mention of the possible need for further rate hikes, repeating its standard language that it would "monitor global and domestic economic and financial developments, including adjustments in the Canadian economy, relative to its projection."

Mark Chandler, senior market economist at Scotia Capital, said the bank seems willing to tolerate bullish signs now in faith that the economy will weaken in the medium term.

"The strength in the Canadian dollar is obviously giving them concern ... They're willing to accept firmer data in the near term and then keep rates on hold," Chandler said.

The risks to inflation and growth remained roughly balanced with a small tilt to the downside toward the end of the 2006-2008 period, the bank said, repeating earlier statements.

It said the economy was operating at just above production capacity but that some moderation in U.S. growth, combined with past interest rate hikes and the exchange rate increases, would help the economy return to capacity by the end of 2008.

Core inflation rose to the 2 percent target sooner than expected and should remain there throughout the 2006-2008 period, the bank said.

It sees overall inflation averaging just above 1.5 percent from mid-2006 to mid-2007, due to the effects of a one percentage point cut in the federal sales tax. The inflation rate should then return to the central bank's 2 percent target, it said.