UPDATE 3-Mexico central bank warns on inflation, holds rate

* Mexico holds benchmark interest rate at 4.5 percent

* Central bank says economy emerging from recession

* Policy-maker warns about inflation (Recasts; adds quote, background)

MEXICO CITY, Sept 18 - Mexico's central bank warned on Friday about an increased threat of inflation while holding borrowing costs steady, saying the economy is emerging from a severe recession.

Policymakers at the bank spent much of this year cutting interest rates to fight Mexico's worst economic downturn since 1932, but now they have their eye on an incipient recovery and a proposal by President Felipe Calderon to raise taxes.

"The most recent data on industrial production and consumer confidence appear to indicate that the economy has touched bottom and a period of expansion has begun," the bank said in a statement following its monthly policy review.

As was widely expected, the bank left the benchmark overnight rate at 4.5 percent for the second straight month.

Shifting gears from previous statements that focused on the dire state of the economy, however, the bank said it would consider possible tax increases and the economic recovery when making future interest rate decisions.

"Future actions ... will take into account how the fiscal package eventually approved by Congress, and the development of the economy, affect inflation," policymakers said.

That led investors to raise bets that the central bank will hike interest rates. The yield on the 28-day TIIE interest rate future contract due in January <TIIF0> rose 5 basis points to 5.29 percent.

"The tone is for tightening," said Benito Berber, an economist at RBS Greenwich Capital.

PULLING OUT OF TAILSPIN

A drop in U.S. demand for exports sent Mexico's economy into a tailspin late last year. Mexico's central bank tried to prop up growth by slashing borrowing costs between January and July, although the economy is still expected to contract about 7 percent this year.

Evidence is mounting that the economy is growing again. Mexican industrial output rose in July at its fastest monthly rate in four years, supported by a rise in automobile production.

For the first time in months, policymakers on Friday did not mention the possibility of lowering rates. The yield on Mexico's 10-year government peso bond <MX10YT=RR> rose nearly 7 basis points to 8.15 percent.

The central bank forecast the economy would grow in both the third and fourth quarters of this year, after it shrank for an entire year, but said the recovery is likely to be slow.

Prices tend to rise faster when the economy is expanding, but the central bank said it is concerned higher taxes could fuel inflation even further.

Lawmakers are debating Calderon's proposal, which would levy a new 2 percent sales tax on all products, including currently exempt food and medicine.

The bank expects inflation to end 2009 around 4 percent, above the bank's 3 percent target rate.