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The annual inflation rate eased more than expected in December to levels closer to the Bank of Canada's 2 percent target, making it easier for the central bank to keep rates low or even cut them if the European debt crisis worsens.
Slower growth in gasoline prices and lower vehicle costs helped push down the consumer price index by 0.6 percent in the month, Statistics Canada said on Friday. December inflation slowed to a year-on-year 2.3 percent, down from 2.9 percent in November.
The core rate, which excludes volatile items like gasoline and gives a more accurate picture of underlying price pressures, slipped 0.5 percent. The annual core rate fell to 1.9 percent from 2.1 percent.
"This is the inflation report that the Bank of Canada had been dreaming about," said Scotia Capital economist Derek Holt in a note to clients.
The central bank held its key interest rate at an ultra-low 1 percent on Tuesday for the 16th straight month and cited the European debt crisis as the biggest threat to the economy. It gave no indication it planned to move rates either up or down.
The bank also raised its inflation outlook slightly, raising fears that it might be more reluctant to ease monetary policy. But Friday's softer inflation data eases those fears.
Analysts surveyed by Reuters had forecast, on average, annual inflation of 2.8 percent in December and a core rate of 2.1 percent.
Overnight index swaps, which trade based on expectations for the central bank's key policy rate, show traders see a chance of a rate cut this year. Those rate-cut bets increased briefly immediately after the inflation data but later faded.
Most economists expect the bank to hold rates steady for the year and begin hiking in 2013. CA/POLL
Indeed, the bank has conceded that inflation, even if it tips higher again, is not its biggest worry and that it will be flexible with its inflation target in light of the threat of a big external shock.
"There's the sense that in terms of monetary policy it's not the cost of money that is the problem for Canada so much as it is the ... uncertainty delivered by the externalities including the EU crisis and certainly some uncertainty on how the global economy is performing," said Stewart Hall, senior currency strategist at RBC Capital Markets.
Analysts said consumers took advantage of heavy holiday discounting in December on clothing, food and other retail items as well as getting a break at the gas pump and on cars.
Gasoline prices rose 7.6 percent year-on-year in December, down sharply from 13.5 percent in November. Passenger vehicle prices dropped by 0.2 percent versus a 1.8 percent gain in November. Food cost 4.4 percent more, down from 4.8 percent.
Some of those discounts may be reversed in January, likely making December's numbers an anomaly, warned Doug Porter, deputy chief economist at BMO Capital Markets.
"I don't know that it's going to be a lasting effect or not. We have had big monthly surprises in Canadian inflation that have tended to fade away," he said.
Statscan also said inflation averaged 2.9 percent over 2011, higher than any year in the previous decade and at the high end of the central bank's comfort zone of 1 to 3 percent.