OTTAWA (Reuters) - The Bank of Canada held interest rates unchanged at 3 percent on Tuesday, as expected, but said inflation could rise above 4 percent for the first time since 2003 as commodity price hikes outpace expectations.

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Even as it flagged inflation as the one development that has taken it by surprise, the central bank did not make any hint of a future rate hike. Instead, it said that the inflation risk was offset by two other major challenges -- a protracted U.S. economic slowdown and financial market turbulence.

"Against this backdrop, the bank judges that the current level of the target for the overnight rate remains appropriate," it said in a statement.

"The bank will continue to monitor carefully the evolution of risks, together with economic and financial developments in the Canadian and global economies, and set monetary policy consistent with achieving the inflation target over the medium term."

The next rate decision is in seven weeks, on September 3.

Consumer inflation should spike sharply above the bank's target range of 1 percent to 3 percent, and peak in the first quarter of 2009, the bank said. Canada has not experienced an annual inflation rate above 4 percent since March 2003.

"Commodity prices are continuing to outstrip earlier expectations. This has led to further increases in Canada's terms of trade and real national income and has altered the outlook for global and domestic inflation," it said.

This was the bank's second upward revision to the inflation outlook since April, when it had expected the rate to stay below 2 percent.

Core inflation, which strips out volatile items like gasoline and food, is seen as more contained, averaging about 1.5 percent through the third quarter.

The bank sees both measures of inflation converging at 2 percent in the latter half of 2009.

Canada's growth rate this year will also take a hit, the bank predicted. It cut the 2008 economic growth projection to 1 percent from 1.4 percent previously. Its forecast for 2009 growth is down to 2.3 percent from 2.4 percent previously, while the 2010 outlook is unchanged at 3.3 percent.

The rate decision marks the second time the bank has kept its benchmark overnight lending target unchanged after slashing rates by 150 basis points between December and April. It brought the rate-cutting campaign to an unexpected halt in June due to inflationary pressure.

Canada's primary securities dealers were unanimous in expecting no rate change on Tuesday. All the dealers surveyed by Reuters also expected the bank to stand pat in September and only two expected a rate change later in the year -- one predicting a cut and one a hike.

Canada's rate remains 1 percentage point above the U.S. federal funds rate of 2 percent.

(Reporting by Louise Egan; Editing by Frank McGurty)