The Bank of Canada held the line on interest rates Tuesday morning — at 4.25 per cent — and gave no sign that it intended to raise its key rate any time soon.

"The current level of the target for the overnight rate is judged, at this time, to be consistent with achieving the inflation target over the medium term," Canada's central bank said in its announcement at 9 a.m. Tuesday.

David Dodge, governor of the Bank of Canada, expressed concern over the U.S. slowdown in his interest-rate announcement Tuesday.

The bank said it would hold the overnight lending rate at 4.25 per cent and the bank rate at 4.5 per cent.

In its announcement, the central bank said Canada was working close to — or just above — its production capacity thanks to strong domestic demand, despite a slowing U.S. economy and lower demand for Canada's exports in the United States.

In a vote of confidence in the Canadian economy, it said it expects Canada's economic growth to pick up to about 2.5 per cent in the first half of 2007, and operate near capacity throughout 2007 and 2008.

That would be good news for Canada. Some economists say the growth in the gross domestic product (GDP) slowed to just 1.5 per cent on an annualized basis in the fourth quarter, well down from earlier projections of 2.8 per cent.

But the Bank of Canada said strong domestic demand was compensating for a slowdown in the U.S. economy.

Domestic demand in Canada has "continued to contribute strongly to growth," the bank noted.

The bank expressed little concern about inflation in its announcement. Total Consumer Price Index inflation is slightly lower than was forecast in October, while monthly core inflation is slightly higher.

Total CPI inflation is expected to average just above one per cent in the first half of 2007, returning to the two per cent inflation target in early 2008. Core inflation is expected to return to two per cent in the first half of 2007 and remain there.

"The Bank continues to judge that the risks to the inflation projection are roughly balanced, but the main upside and downside risks outlined [in its previous forecast in October] have diminished somewhat," the bank said.

Slowing U.S. economy

In its report, the bank expressed some concern over the slowing U.S. economy and the impact it would have on Canadian exports.

"With weaker U.S. growth, output growth in Canada decelerated, likely averaging about 1.6 per cent in the second half of 2006," the bank said, adding that the slowdown was largely due to lower U.S. demand for building materials and motor vehicles, and the need for Canadian companies to reduce their inventories.

Much of the impact has already passed.

"There are signs that a significant amount of the adjustment in the U.S. housing and automotive sectors has already taken place and that the inventory correction in Canada is well advanced," the bank said.

In its commentary RBC Financial Group said it expects the bank to hold interest rates steady until mid-year when a rate cut is likely.

"Today’s statement indicates mild alterations to the growth and inflation forecasts with the detailed projections to be released in Thursday’s Monetary Policy Report Update," RBC said. "On balance, we see little in today’s statement that changes our view that the Bank’s next move will be to lower the overnight rate to 4% this summer."

The bank has held its key overnight lending rate at 4.25 per cent since May 24, 2006, despite major changes in other countries

The Bank of England raised its minimum lending rate to 5.25 per cent last week, the third hike since August 2006 and the highest level in more than five years. It is expected to raise its rates again in coming months after reporting that inflation rose by three per cent in December on an annualized basis.

The European Central Bank began raising its minimum bid rates in December 2005, moving them up 25 basis points to 3.5 per cent on Dec. 7.

The big question is what the U.S. Federal Reserve will do at its next rate-setting meeting, on Jan. 30. It is expected to leave rates where they are for the time being at 5.25 per cent despite the contradictory factors of good job growth, a slowing economy, sharply lower oil prices and little impact from a slump in housing.