By Randall Palmer and Leah Schnurr
OTTAWA/TORONTO (Reuters) - Canada's annual inflation rate jumped unexpectedly last month to its highest in 1-1/2 years, alleviating concern that the country is headed for disinflation and reducing the likelihood the Bank of Canada will be forced to cut already low interest rates.
But the impact of the positive inflation data was offset by a figures that showed a slump in retail sales in December as harsh winter weather kept consumers at home. The drop was the biggest in 12 months and reinforced expectations that the economy likely shrank in the last month of 2013.
Canada's annual inflation rate rose to 1.5 percent in January from 1.2 percent in December, Statistics Canada said on Friday, above economists' expectations for a 1.3 percent increase. The last time the consumer price index (CPI) was as high as 1.5 percent was in June 2012.
The central bank targets inflation of 2 percent and tries to keep it within a range of 1 to 3 percent. The bank has had to balance its apprehension about low inflation with its concern about the effect that providing further monetary stimulus might have on already high household debt levels and housing prices.
"The strong CPI number that we got is a clear reflection of the fact that we don't have a disinflationary trend in Canada and some of the decline, or softness, in prices was basically based on noise," said Benjamin Tal, senior economist at CIBC World Markets, in Toronto.
Higher costs for shelter boosted the inflation rate on an annual basis in January, while higher costs for passenger vehicles, natural gas, electricity and water drove prices up on a monthly basis.
Economists expect the increase in prices in February will not be as strong as in January as it will be measured against a sharp rise in February 2013.
Worried by weak inflation, the Bank of Canada shifted policy gears last year, dropping any mention of an increase in interest rates. In its last policy announcement, it left the door open to a rate cut.
"Higher inflationary pressure in Canada, or at least the end of disinflation pressures, feeds directly into Bank of Canada expectations and will remove any pricing for an interest rate cut in Canada," said Camilla Sutton, chief currency strategist at Scotiabank.
The central bank's next policy announcement will come in early March.
The inflation data helped the Canadian dollar pare a decline on Friday, while traders pulled back their already small bets on a rate cut in 2014.
On a monthly basis, consumer prices rose to 0.3 percent in January, again more than expected, after a decline of 0.2 percent in December.
Core inflation, which excludes volatile items such as fruit and gasoline and is watched by the Bank of Canada, also came in higher than expected at 1.4 percent on an annual basis and 0.2 percent on a monthly basis.
A separate report showed extreme winter weather helped slash Canadian retail sales by 1.8 percent on a seasonally adjusted basis in December, far worse than the 0.4 percent drop economists had expected.
The volume of retail sales, a factor in calculating real gross domestic product (GDP), fell by even more, 2.2 percent. December and fourth-quarter GDP data are due out next Friday.
"This all but assures that the impressive five-month run for the Canadian economy through November came to a screeching halt in the final month of 2013," said Robert Kavcic, senior economist at BMO in Toronto.
"There's nothing pretty in this report, or in the December Canadian data in general, with nasty weather clearly having at least some impact."
A host of other data has already pointed to a weak December, including a drop in employment, wholesale trade, manufacturing sales, building permits and a wider trade deficit, with weather pointed to as a factor throughout.
The run of disappointing data opens up downside risk for fourth quarter GDP, as well as for economic growth the first quarter of 2014, Kavcic said.
(Additional reporting by Solarina Ho in Toronto; Editing by Peter Galloway)