June 18 (Bloomberg) -- Canadian consumer prices posted an unexpected annual increase last month on higher costs for food and household needs such as child care, reducing the Bank of Canada’s scope to keep interest rates at record lows.

The consumer price index rose 0.1 percent in May from a year earlier and 0.7 percent from the previous month, Statistics Canada said today in Ottawa. Economists predicted the index would decline 0.2 percent on the year and rise 0.4 percent from April, based on the median of 21 responses in a Bloomberg survey.

The report indicates that deflation, or prolonged price decreases, isn’t a danger for the world’s eighth-largest economy even as the country struggles with mounting job losses and tumbling sales for manufacturers. The Bank of Canada cut its benchmark interest rate to 0.25 percent on April 21 and pledged to keep the rate there until June 2010 because of a buildup of spare capacity in the economy.

“The data shows signs of slight inflation. That means the economy here is recovering and the Bank of Canada might have to raise rates faster than anticipated,” said David Love, trader of interest-rate derivatives at Le Group Jitney Inc. in Montreal.

Canada’s dollar gained 0.4 percent against its U.S. counterpart after the report, trading at C$1.1274 per U.S. dollar at 10:32 a.m. in Toronto, from C$1.1318 yesterday.

Asset Purchases Less Likely

The Bank of Canada, which implements policy to keep inflation at 2 percent, has said it would be prepared to inject new money into the economy by purchasing assets if needed. Today’s report “likely lessens” the chances of asset purchases, said David Watt, senior currency strategist in Toronto at RBC Capital Markets, a unit of Canada’s biggest bank.

Canada’s economy contracted at a 5.4 percent pace in the first quarter and may shrink at a 2.2 percent rate in the second quarter, according to the median of 15 estimates in a Bloomberg survey.

With rates at 0.25 percent, which Carney has called “the lowest-possible level,” the Bank of Canada last April committed to keeping borrowing costs at the record low to fuel lending. The time commitment can help reduce long-term interest rates, which are largely a “reflection of expected future short rates,” John Murray, deputy governor of the Bank of Canada, said in a speech last month.

Swap Rates Rising

Canada’s one-year overnight swap rate rose today to 0.4125 percent from 0.3855 yesterday, and is up from as low as 0.2735 percent April 24, indicating fewer investors are heeding that commitment.

Still, Bank of Canada Governor Mark Carney, who is due to give a speech today in Regina, Saskatchewan at 2 p.m. New York time, will be reluctant to move away from his pledge to keep interest rates unchanged until there are clear signs the inflation outlook has changed, said Mark Chandler, a fixed- income strategist at RBC Capital Markets.

“You will need a string of inflation reports that are beyond expectations to break their promise,” Chandler said.

Statistics Canada said today the annual inflation rate excluding gasoline and seven other volatile items -- the so- called core rate which is closely watched by the central bank -- accelerated to 2 percent from 1.8 percent in April. Economists surveyed by Bloomberg had expected the core rate to slow to 1.6 percent.

Inflation to Turn Negative

The central bank projects the consumer price index will fall at an annual pace of 0.8 percent in the third quarter of this year, and inflation will not return to target before the second half of 2011. The annual inflation rate in April fell below the central bank’s target range of 1 percent to 3 percent for the first time since September 2006.

Food prices were up 6.4 percent in May from a year earlier, while the costs of household operations, furnishings and equipment rose at a 3.2 percent annual pace during the month, led by child-care expenses, the statistics agency said.

Gasoline prices fell 25 percent from a year ago, helping to limit the rise of the annual index, the statistics agency said, while the cost of buying a car dropped 6.6 percent.

On a monthly basis, core prices rose 0.4 percent. Economists surveyed by Bloomberg expected the monthly core inflation rate to remain at 0.1 percent, based on the median of 19 responses.

To contact the reporters on this story: Theophilos Argitis in Ottawa at targitis@bloomberg.net; Chris Fournier in Montreal at cfournier3@bloomberg.net.

Last Updated: June 18, 2009 11:25 EDT