OTTAWA (Reuters) - The Bank of Canada raised its key interest rate on Tuesday for the first time in over a year and kept the door open to further hikes, saying inflation has been persistently higher than it expected.

The bank hiked its overnight lending rate by one-quarter point to 4.50 percent in what analysts see as the beginning of a tightening cycle after a long pause.
"Some modest further increase in the overnight rate may be required to bring inflation back to the target over the medium term," the central bank said in a statement explaining its first rate hike since May 2006.

The language was similar to that used March and April 2006, one month before rate hikes.

However, the bank also said the risks to its inflation outlook appear to be roughly balanced. On the one hand, stronger-than-expected household demand in Canada could push inflation higher while on the other, an appreciation of the Canadian dollar and the U.S. housing downturn could help keep prices steady.

The Canadian dollar surrendered gains against the U.S. dollar after the announcement. The currency had touched a new 30-year high last week.

Canada's primary securities dealers had unanimously expected the rate hike in a poll last Friday because the central bank telegraphed its intentions in a May 29 statement.

But they were divided on the pace of the monetary tightening cycle as some softer economic data has made a second rate hike in September less of a certainty. Eleven out of 13 dealers forecast another quarter-point hike at the bank's next decision on September 5. Three saw a rate increase in October, versus 10 who saw no change.

Canada's core inflation, which excludes volatile items like gasoline, was 2.2 percent in May, down from a four-year high of 2.5 percent in April but not enough to persuade the bank that its inflation woes are over.

The bank now sees both total inflation and core inflation, which excludes volatile items, staying above its 2 percent target until early 2009. Previously, it had seen total inflation declining to 2 percent by mid-2008 and core inflation reaching the target by the end of 2007.

The economy is operating further above its production potential than was expected in April, the bank said, and it now sees the Canadian economy expanding by 2.5 percent in 2007 instead of 2.2 percent previously.

Growth will moderate in 2008 and 2009 to about 2.5 percent annually on the effects of the strong Canadian dollar and higher interest rates, the bank said. It previously forecast growth of 2.7 percent in both years.