PREVIEW-Bank of Canada seen keeping rates on hold Oct. 25

WHAT: Bank of Canada interest rate announcement

Monetary Policy Report

WHEN: Tuesday, Oct. 25, at 9 a.m. EDT (1300 GMT)

Wednesday, Oct. 26, at 10:30 a.m. (1430 GMT)

FORECASTS: All 40 economists and strategists polled by Reuters see the Bank of Canada maintaining its overnight target rate on Tuesday at 1 percent. The median forecast is for the next rate hike to not be before the third quarter of next year.

That said, yields on overnight index swaps, which trade based on expectations for the key central bank rate, show investors expect the bank's next move, eventually, to be down rather than up.

FACTORS TO WATCH

LANGUAGE ON RATE DIRECTION: The Sept. 7 rate decision eliminated the previous language that stimulus "will be withdrawn", saying instead "the need to withdraw monetary policy stimulus has diminished."

Since then, the European debt crisis has deteriorated and predictions for U.S. and Canadian growth have been downgraded, giving more reason for caution.

Pushing in the opposite direction, Canadian inflation has exceeded expectations and is outside the central bank's target zone of 1 to 3 percent. Annual inflation in September was 3.2 percent, and the core rate rose to 2.2 percent, the highest since December 2008. Though markets continue to price in an eventual rate cut, analysts think September's hotter-than-expected inflation puts paid to that idea.

FLEXIBILITY: Governor Mark Carney said in a Sept. 20 speech that the Bank of Canada maintains a "flexible approach" in setting rates, suggesting rates could stay lower for longer than they normally would.

Emphasis on flexibility would suggest any rate hikes will be later rather than sooner.

INFLATION TIMELINE: Integral to the concept of flexibility is the time horizon over which inflation should be expected to return to the 2 percent target. The bank has typically used six to eight quarters but Carney mused in September about extending that.

In July, the bank had forecast total inflation of only 2.8 percent in the third quarter, returning to 2 percent by the middle of 2012. It saw core inflation at 1.9 percent in the third quarter, rising to 2.1 percent in the first quarter of 2012 and then back to the target by the second quarter. The bank will most likely have to raise the expected inflation profile in Wednesday's Monetary Policy Report.

RISKS: In July, the bank said the risks to its outlook were roughly balanced. Shifts to an upside or a downside bias will give further hints about the timing and possibly direction of rates.

CANADIAN DOLLAR: The economic headwinds from the Canadian dollar have lessened as the currency returned to below parity with the U.S. dollar. The July report had assumed a Canadian dollar worth $1.03 U.S., or 97.09 Canadian cents to the U.S. unit.

GROWTH: Growth forecasts will be downgraded. The July report saw annualized growth of 2.8 percent in the third quarter and 2.9 percent in the fourth. The bank still expects that the third quarter was positive, after a 0.4 percent fall in the second, but sees it sharply lower than the originally forecast 2.8 percent. The annual growth forecast was for 2.8 percent in 2011, 2.6 percent in 2012 and 2.1 percent in 2013.

OUTPUT GAP: The markets are looking for any adjustments in the bank's July forecast that the economy would return to full capacity in mid-2012.

MARKET IMPACT

Any hint the bank is prepared to accept above-target inflation or will be even more prudent in any decision to raise rates would be expected to weigh against the Canadian dollar and lower bond yields, as would a downside tilt on the risks.

Expressions of concern on inflation or hints of an upside bias would lend support to the Canadian dollar and bond yields.