* Annual inflation 0.5 pct in Jan, down from 0.8 pct in Dec
* Retail trade drops 2.1 pct in Dec from Nov
* Both figures are weakest in about three years
* Expectations soften for GDP and for rate increase
OTTAWA, Feb 22 (Reuters) - Canada's economy registered its lowest inflation in more than three years in January and the largest decline in retail sales in almost three years in December, a double whammy that weakened the currency and darkened the country's growth outlook.
Friday's Statistics Canada reports prompted several economists to water down forecasts for December and fourth-quarter gross domestic product data, which is due March 1 .
They also pushed out expectations for the next Bank of Canada interest rate increase and raised the possibility that the central bank could tone down its policy-tightening language further than it has already in the past few months.
"This combination of data just piles on what had already been a weak footing for the Canadian dollar," BMO Capital Markets chief economist Doug Porter said. "Both numbers came in below already weak expectations. Obviously the real eye-opener here was the retail sales result."
The Canadian dollar softened to its weakest level in nearly eight months on the data, touching C$1.0256 versus the U.S. dollar, or 97.50 U.S. cents.
DAMPENS RATE HIKE TALK
Statistics Canada said lower gas prices helped push the annual inflation rate down to 0.5 percent in January from 0.8 percent in December, the lowest level since the 0.1 percent recorded in October 2009.
The annual rate was less than the 0.7 percent forecast by market analysts and further outside the Bank of Canada's target range of 1 to 3 percent, offering more evidence that the central bank is under no pressure to raise interest rates.
"All of this would feed into a dovish Bank of Canada and Canadian dollar weakness," said Camilla Sutton, chief currency strategist at Scotiabank.
The Bank of Canada's closely watched core inflation rate, which excludes the prices of items such as energy, tobacco and some food, slipped to 1.0 percent from 1.1 percent in December.
Sutton also noted with concern that on a seasonally adjusted basis, prices fell 0.1 percent in January from December.
The 2.1 percent fall in seasonally adjusted retail sales in December from November was far larger than the 0.3 percent decline predicted by market operators and suggested already muted expectations for fourth quarter growth might be too optimistic.
The monthly fall in retail sales was the greatest since the 2.4 percent decline recorded in April 2010. Trade was pulled down by slumping new car sales and a weak Christmas shopping season, though some of this was because some purchases were advanced to Black Friday in November. Year on year, sales were down 0.7 percent, the worst performance since October 2009.
GROWTH FORECASTS CUT
Last month the Bank of Canada cut its fourth-quarter growth forecast from an annualized 2.5 percent to 1.0 percent. But most forecasters say even that is too optimistic. The median forecast in a Reuters poll is 0.6 percent in the fourth quarter.
The consensus is that GDP will contract in December, weighed down by declines in manufacturing, wholesale and retail trade.
In volume terms, used for calculating real GDP moves, retail sales fell 1.6 percent in December from November.
Sales by auto and parts dealers dropped by 6.4 percent Sales at electronics and appliance stores, which jumped in November as Apple rolled out its iPad mini, fell by 12.1 percent.
BMO's Porter said he had been looking for a decline in retail sales, but nothing on the order of the actual fall. "And of course December just happens to be the most important month of the year for retailers. So obviously what had been a so-so year for retailers ended with a thud in December."
Overnight index swaps, which trade based on expectations for the central bank's key policy rate, showed that after the data traders eliminated already small bets on a rate increase in late 2013.
The Bank of Canada insists that its next rate move is likely to be up, but has said that an increase is not as imminent as it had once thought.
Further guidance may come on Monday from a speech and news conference by bank Governor Mark Carney.
Adding to the economic slowdown is a cooling of Canada's housing market. The federal housing agency on Friday said it expected housing starts of 178,600 to 202,000 this year, down from 214,827 in 2012.