* Overall annual inflation rate 3.2 pct vs 3.1 pct in Aug
* Core rate 2.2 pct, highest since Dec 2008
* Energy, food, clothes explain higher CPI
* Rate cut expectations scaled back, C$ firms
By Louise Egan
OTTAWA, Oct 21 Canada's annual core inflation rate jumped in September to its highest level in nearly three years, causing traders to scale back the likelihood of central bank interest rate cut this year or next.
The core rate sped up more than expected to 2.2 percent from 1.9 percent in August, according to Statistics Canada data on Friday. The core index is considered a better gauge of price trends because it excludes eight volatile items including gasoline and food.
"From a policy point of view, the increase in core has got to be of the greatest concern," said Paul Ferley, assistant chief economist at the Royal Bank of Canada.
"Certainly it will shift expectations or put more weight to the next (rate) move being an increase, but, near-term, those external pressures keep the Bank of Canada on the sidelines," he said.
The overall annual inflation rate came in at 3.2 percent, remaining above the central bank's traditional comfort zone and a notch above forecasts, as consumers were hit by higher gasoline and food prices.
The return of price pressures at a time of weak growth has been seen across many industrialized countries. Canada's inflation rate, which has eased from a 5-1/2 year-high of 3.7 percent in May, remained tamer in September than the U.S. rate of 3.9 percent or Britain's 5.2 percent, both three-year highs.
Finance Minister Jim Flaherty said he was not too worried by the inflation report.
"I'm more concerned quite frankly about growth, economic growth, and I'm pleased that we are seeing reasonable, moderate economic growth in Canada and some good signs in the United States. I wish I could say that of Europe," he told reporters.
The Canadian dollar firmed after the data to a session high of C$1.0067 to the U.S. dollar, or 99.33 U.S. cents, up from Thursday's North American close at C$1.0150, or 98.52 U.S. cents.
The Bank of Canada targets annual inflation of 2 percent within a control range of 1-3 percent. But Governor Mark Carney has signaled he is willing to keep the benchmark interest rate at an ultra-low 1 percent amid what he considers transitory inflationary pressures because he is more worried about the European debt crisis and the potential for another global recession.
Economists and strategists expect the Bank of Canada to keep rates on hold next Tuesday and beyond, with a increase coming in the third quarter of next year, according to a Reuters poll.
However, traders had been pricing in a rate cut, rather than a hike next year. Overnight index swaps, which trade based on expectations for the central bank's key policy rate, showed that traders scaled back bets on a rate cut following the release of the inflation data.
Sheryl King of Bank of America-Merrill Lynch said she expects the Bank of Canada will send a message to markets in its rate announcement next week that monetary easing is out of the question.
"The odds are that the Bank of Canada is not going to deliver a particularly dovish tone in their press release, not just because of this," she said.
She added the bank should take price pressures more seriously because high commodity prices are being passed through to consumers and the Canadian dollar has come down from recent highs, with less of a dampening effect on prices.
"This is going to be very challenging for the bank for the next little while because I think they are underestimating how much further inflation is going to rise."
Excluding just food and energy, annual inflation was a tamer 1.9 percent.
On a monthly basis, the all-items CPI index edged up 0.2 percent in September compared with 0.3 percent in August. Core CPI rose 0.5 percent versus 0.4 percent in the prior month.