ANALYSIS-Is the worst over for inflation in Canada?

By Louise Egan

OTTAWA, Aug 25 (Reuters) - It may be odd for a rise in inflation to prompt calls for interest rate cuts, but that paradoxical view prevails in Canada after inflation stayed above the central bank's target range for two straight months.

Canadians saw the value of their money shrink in July as soaring gasoline prices drove inflation to a five-year high of 3.4 percent. Yet there was an almost audible sigh of relief among those who had been bracing for the worst and many declared July as the peak for inflation, pointing to an ebb in oil prices since then.

Quickly rejigging forecasts, some analysts now expect the Bank of Canada to cut interest rates sooner to stimulate sagging economic growth. At least one has backed down from a prediction for a rate hike later this year to curb inflation and the market has priced in a 50 percent chance of a rate cut in the fourth quarter.

"Markets and to some extent forecasters are rightly identifying that the rise in inflation that we've seen over the past four or five months ... reflects an economic and pricing environment that really doesn't exist anymore," said David Wolf, chief economist at Merrill Lynch Canada.

Wolf expects two rate cuts of 25 basis points each in December and January.

The Bank of Canada -- which has projected inflation would not peak until hitting 4.3 percent in early 2009 -- has its last chance to reveal its thinking on rates in a speech on Tuesday by Deputy Governor David Longworth.

"I guarantee that if the Bank of Canada produced an inflation forecast right now, using the current (oil) futures strip, they wouldn't be projecting inflation up to 4 percent later this year," said Wolf.

If true, it would be another turnaround for Governor Mark Carney, who abruptly halted a rate-cutting campaign in June due to what he later called a "commodity super cycle" or an exceptionally lengthy period of rising commodity prices.