(Adds Governor Macklem press conference)
By Julie Gordon and David Ljunggren
OTTAWA, Jan 20 (Reuters) - The arrival of a COVID-19 vaccine and stronger foreign demand is brightening the outlook for the Canadian economy in the medium term, the Bank of Canada said on Wednesday, as it held its key overnight interest rate at 0.25%.
But the central bank warned the economy would contract in the first quarter of 2021 amid a resurgence of COVID-19 cases and lockdowns, with inflation not expected to return sustainably to target until 2023, keeping interest rates at record lows.
"There is clear reason to be more optimistic about the direction of the economy over medium term. But we are not there yet," Governor Tiff Macklem told reporters after the rate decision and new forecasts were released.
"Unfortunately we're in a very serious chop. This decline in activity that we're expecting this quarter ... is larger than we had expected, we are moving in the wrong direction right now," he later added.
The Canadian dollar CAD= notched its strongest level in nearly three years after the rate decision, touching 1.2606 to the greenback, or 79.33 U.S. cents, before giving back some of its gains.
Macklem, when asked about the potential for a micro rate cut, said reducing the effective lower bound without going negative was still an option, should the economy turn out "substantially weaker than our outlook."
He added that the bank's governing council had carefully weighed the current weakness and determined that no change in stimulus was needed at this point.
The Bank of Canada expects the Canadian economy to contract at an annualized rate of 2.5% in the first quarter of 2021, with full year economic growth now forecast to be 4.0%. Economic activity is expected to return to pre-pandemic levels in late 2021, slightly sooner than forecast in October.
The Bank also revised up its growth projection for 2022 to 4.8% and forecast 2.5% GDP growth in 2023.
"The main message here is the bank is more confident about the medium-term outlook," said Doug Porter, chief economist at BMO Capital Markets.
Macklem noted that a stronger Canadian dollar could become a headwind, with further appreciation presenting a downward risk to the Bank's projections.
The central bank's economic projections also assume broad immunity to COVID-19 will be obtained through vaccination by the end of 2021, but risks remain.
"The timing and strength of the economic recovery will depend importantly on the evolution of the virus and the rollout of vaccines," said Macklem. ($1 = 1.2624 Canadian dollars)