By Julie Gordon and David Ljunggren

OTTAWA (Reuters) -The Bank of Canada still expects economic slack to be absorbed in the middle quarters of 2022, but that does not necessarily mean in the second quarter, a deputy governor said on Tuesday, potentially dashing market hopes of an early rate hike.

Lawrence Schembri, in an audience question and answer session after a speech on labor market uncertainty, reiterated that increases to the benchmark rate will only come when excess capacity is absorbed so that the central bank's 2% inflation target is sustainably achieved.

"There's a lot of uncertainty about the timing of the closing of the output gap, so one should be careful not assuming it's necessarily going to be the second quarter. It's a range of six months -- that's our best estimate," he said.

The Bank of Canada said last month that the output gap could close as soon as April 2022, leading to higher interest rates. Governor Tiff Macklem on Monday said that while economic slack has not yet been absorbed, it is getting closer.

Money markets are betting the first hike will come in March 2022, with five increases next year. The bank slashed its key overnight rate to a record low 0.25% in March 2020 as the COVID-19 pandemic erupted.

Knowing exactly when the output gap has closed is becoming more difficult, Schembri said in his speech, as the relationship between labor market conditions and inflation has weakened and become harder to measure.

Traditionally, inflation should come back to target when economic slack is absorbed and the economy returns to maximum employment. But structural shifts in the labor market were accelerated by the pandemic, and those changes have made traditional tools to measure slack less useful, he said.

"The evidence for Canada indicates that the relationship between labor market conditions and inflationary pressure has weakened and become difficult to measure — especially in periods of excess demand," he said.

"This uncertainty is closely related to the ambiguity about the level of maximum sustainable employment."

Schembri said the bank had developed new tools to measure the impact of the pandemic on employers and workers and was looking at new ways to measure slack in the labor market.

The Canadian dollar was trading 0.3% lower at 1.2554 to the greenback, or 79.66 U.S. cents as the U.S. dollar gained ground against a basket of major currencies.

(Reporting by Julie Gordon and David Ljunggren in Ottawa; additional reporting by Fergal Smith in Toronto; Editing by Cynthia Osterman)