UPDATE 1-Mexico cenbank warns rebound is fueling inflation

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MEXICO CITY, March 19 (Reuters) - Mexico's central bank said on Friday it could raise interest rates because an improving though still weak economy is starting to fuel price rises, threatening its end-2011 inflation target.

The bank held its benchmark overnight interest rate steady at 4.5 percent, as was widely expected.

But in its policy statement, it warned that Mexico's march back from recession was increasingly allowing higher taxes and government-set prices to fuel inflation.

"As the output gap closes, (the gap's) ability to reduce ... inflationary pressures from fiscal changes and public-sector prices is shrinking," the bank said, adding that Mexico's economy would still perform below its potential this year.

The bank said it could "adjust monetary policy so as to meet the goal of 3 percent inflation by the end of next year." It did not indicate when it might raise borrowing costs.

The decision to keep the rate MXCBIR=ECI steady on Friday was unanimously expected by 25 economists consulted in a Reuters poll. (Reporting by Jason Lange, Editing by Chizu Nomiyama)