OTTAWA - The Bank of Canada has brightened its outlook for the Canadian economy, saying Tuesday it now thinks this year's downturn won't be as deep as previously forecast and 2010 growth will be stronger.

The bank did as expected in keeping its key policy rate at the historic 0.25-per-cent low and repeating a pledge to keep it there until the spring of 2010.

But in a surprising move, the central bank said it is reducing the amount of money it is making available to chartered banks in order to support borrowing and lending because the need for such extraordinary measures is waning.

And it came as close as it has ever done to predicting the end of the most severe recession since the Second World War.

"There are increasing signs that economic activity has begun to expand in many countries," the central bank said in an accompanying statement.

"(In Canada,) stimulative monetary and fiscal policies, improved financial conditions, firmer commodity prices, and a rebound in business and consumer confidence are spurring domestic demand," it added.

Bank of Montreal economist Douglas Porter said the outlook was brighter than expected, considering the caution recommended by bank governor Mark Carney's most recent public statements.

"They didn't quite say 'Ding Dong, the Recession's Dead,' but I think they really wanted to," Porter said.

"They danced all around the topic."

He bases that conclusion on the bank's new numbers on future growth.

Carney is now forecasting the Canadian economy will shrink by 2.3 per cent this year - a big improvement from April's three per cent contraction forecast - and grow half-a-point more than projected at three per cent in 2010.

Given how far the economy fell back in the first half of 2009, it is virtually impossible for the deterioration to be held to 2.3 per cent for the entire year without growth beginning now, during the current third quarter, Porter said.

CIBC chief economist Avery Shenfeld noted that the three per cent growth projection for next year once again puts Carney among the most optimistic of analysts. Most private sector forecasts have the advance at about two per cent.

Even so, Carney is making clear that he has not changed his mind that the road back to where the economy stood before the recession will be long and arduous, saying it will not be until mid-2011 before the economy will be running on all cylinders again.

Part of the reason is that restructuring in the auto, forestry and other sectors will take time and will hold back economic activity. The other is that the return of a strong dollar will hold back exports.

"The Canadian dollar, as well as ongoing restructuring in key industrial sectors, is significantly moderating the pace of overall growth," Carney said.

After falling back in June, the loonie is now back into the territory that caused Carney to warn the currency's rapid rise threatened to "fully offset positive factors" in the economy. It was trading up at close to 91 cents US Tuesday morning.

But Carney gave no indication he favours intervention. If anything, Carney's latest warning about the dollar represents an easing of the previous concern, said Paul Ferley, assistant chief economist with the Royal Bank.

That suggests that although Carney wished the dollar were lower, he is unlikely to break the hands-off approach to the current has followed for over a decade, said several economists.

Besides, a high dollar is not all bad news for Canada, notes Scotiabank economists Derek Holt and Karen Cordes in a note.

"While a stronger dollar does increase the price of exports, conversely, it also decreases the price of imports," they wrote. "And Canada's imports propensity of the components of final demand is quite high, suggesting that Canada also benefits from a stronger dollar."

Carney's other Tuesday surprise was his strong statement about improving financial markets.

The decision to reduce the level of money the bank is injecting into the system had been suggested by some economists, noting that in some cases banks were not drawing down as much as the Bank of Canada was making available.

Some instruments were not being used at all recently.

Carney appeared to signal that he may be preparing to phase out the unconventional instruments put in place when credit markets seized up as early as this fall.

"Conditions in funding markets have continued to improve," he explained in a separate statement.

"Indicative measures of bank funding costs ... have declined steadily from the September 2008 peak to stabilize at their lowest levels since the onset of the financial crisis."

The central banker noted, however, that he remains committed to providing liquidity "as required," to support the stability of the financial system.