UPDATE 2-Sri Lanka keeps rates steady as inflation seen contained

* Sri Lanka keeps policy rates unchanged as expected

* Inflation seen contained at single digits

* Central bank says still vulnerable to inflation risks

* But chances are inflation will moderate rather than rise (Adds cenbank governor quotes)

By Shihar Aneez and Ranga Sirilal

COLOMBO, Sept 18 (Reuters) - Sri Lanka's central bank kept policy rates unchanged on Tuesday, as expected, on expectations that inflation will be contained within single digits due to policies adopted to manage demand, but said price pressures will prevail.

The central bank has already raised the key policy rates twice since February, allowed a flexible exchange rate, and limited this year's credit growth to prevent twin deficits in trade and balance-of-payments.

Sri Lanka's central bank kept the repo rate at 7.75 percent and the reverse repo rate at 9.75 percent, unchanged for the fifth straight month, as most analysts expected.

"We think that inflation vulnerability still remains, but the chances are that it will be more on the side of moderating than increasing," Central Bank Governor Ajith Nivard Cabraal told Reuters in a telephone interview.

Inflation in August eased to 9.5 percent from a year earlier from a 42-month high of 9.8 in July on improved food supplies.

"It moved up a little more than we expected particularly because of the drought. But last month it moderated slightly and this month we also believe it will stay flat. So that means we may not need any further action in the very near future."

Last month, Cabraal said there was no need for a monetary policy response to rising inflation which he attributed largely to supply constraints following the drought.

The central bank said in its policy review that demand management policies were expected to help contain inflation at single-digit levels. Pressures had eased with average monthly credit expansion almost halving to 27 billion rupees during April-July compared with the first three months, it said.

SLOWING ECONOMY, EXTERNAL TRADE

Tight monetary policies and a flexible exchange rate have already helped to boost external reserves by almost a quarter to $7.1 billion in the five months through end-July and reined in Sri Lanka's trade deficit amid the global slowdown.

Growth in the $59 billion economy eased to a 2-1/2-year low of 6.4 percent in the second quarter from a year earlier as the central bank's tight monetary policy and flexible rupee exchange rate weighed on external trade.

The rupee has fallen more than 16.5 percent against the U.S. dollar since November, swelling the cost of Sri Lanka's imports .

The central bank has revised down its original 8 percent target to 7.2 percent, from last year's record 8.3 percent.

The Finance Ministry has said the growth may range between 6.7 percent and 7.2 percent depending on the impact of a drought that has lasted since the beginning of the year. The International Monetary Fund has also lowered its forecast to 6.75 percent this year from an earlier estimate of 7.5 percent.

Cabraal, however, said the central bank will maintain its growth target at 7.2 percent for the time being.

"We think it is still on track. But we will do a complete review in the next few days now that the figures are out for the first half and we will see whether it needs any change in the 7.2 percent figure," he said.

"There is a tendency, when the trade deficit falls, for the exchange rate also to appreciate to some extent," he said. (Editing by Jacqueline Wong)