The consumer price index slipped 0.1 percent in August from the previous month for an annual inflation rate of 1.7 percent, down from 1.8 percent in July, Statistics Canada said on Tuesday.

The market consensus forecast had been for a flat monthly reading and a 1.9 percent annual rate.

Core CPI, which strips out volatile items and the effects of tax changes, rose 0.1 percent in the month to a rate of 1.6 percent on the year, unchanged from July.

The tame prices were not a huge surprise to markets, but do suggest the Bank of Canada's latest forecast of 1.8 percent annual core inflation in the third quarter is too high.

The lack of inflation pressure combined with data pointing to a weaker growth rate suggest the central bank can comfortably sit on the sidelines for the rest of 2010 after raising its benchmark interest rate three times since June.

"If the bank is looking for a reason not to continue hiking rates, inflation would certainly help out that argument," said Doug Porter, deputy chief economist at BMO Capital Markets.

"If the growth side slides further, then inflation is no block to them from keeping rates unchanged if that's what they decide to do," he said.

The Bank of Canada targets an annual inflation rate of 2 percent but tolerates a range of 1-3 percent. Its next rate decision is October 19.

The Canadian dollar fell sharply after the report as investors bet rates would stay low longer. The currency hit a session low of C$1.0325 to the U.S. dollar, or 96.85 U.S. cents, compared with C$1.0285 to the U.S. dollar, or 97.23 U.S. cents, shortly before the data was released. It later weakened further before rebounding to trade little changed on the day.

Canadian government bond yields were little changed or lower.

PRICES LOW ACROSS THE BOARD

Markets were pricing in a 63.25 percent probability the bank would hold rates steady in October, according to Reuters' calculation based on overnight index swaps, which trade based on expectations for the central bank's policy rate.

Food, home and mortgage insurance and natural gas costs all exerted downward pressure on the CPI on a monthly basis, Statscan said. Six of the eight CPI components fell in the month.

But prices rose year-over-year in all categories except clothing and footwear, although the pace of the hikes eased in some cases.

For example, gasoline prices climbed 1.9 percent in the 12-month period compared with a 4.8 percent increase in the year to July.

Shelter costs rose 2.4 percent from a year earlier as households paid more for electricity, rent and natural gas, but that was a slower rate than in July.

Markets were also watching for any impact of a new blended federal-provincial sales tax that went into force in July in two major provinces, Ontario and British Columbia. So far, the new tax regime appears to have done little to nudge up the national inflation rate.

Analysts see no real threat of deflation either but do predict a prolonged period of low prices as the economy struggles to regain traction after a promising start to the recovery late last year.

"In particular, a slowdown in consumer spending will likely continue to put pressure on retailers to continue to provide price incentives to attract buyers - particularly on big-ticket items such as vehicles," said Diana Petramala, economist with TD Securities.

Courtesy of Reuters