The Bank of Canada cut its key interest rate by a quarter of a percentage point Tuesday, citing the increased risks to Canada's economy from the weakness south of the border.

The cut lowered the bank's overnight lending rate — what banks charge each other for overnight loans — to 4.25 per cent. It's the first cut in the central bank's key rate in more than 3½ years. 

The chartered banks quickly lowered their prime lending rates by a quarter of a percentage point to six per cent, effective Wednesday. 

Tuesday's interest rate cut will mean cheaper borrowing costs for Canadians with variable rate mortgages, lines of credit and other loans with floating rates.

The rate cut also led to a further drop in the recently-sagging Canadian dollar. The loonie lost 1.2 cents, closing at 98.78 cents US. 

Some economists say the loonie's slide from its top of $1.10 US just four weeks ago has a way to go yet. Phillips, Hager & North chief economist Patricia Croft, for instance, has a long-range forecast of 85 cents US for the Canadian dollar.

"For Canadians who wanted to convert those dollars and shop in the United States, I suggest you may want to hurry up and do that," she told CBC News.    

Strong economy

The central bank said the Canadian economy continues to operate above its production capacity, which is putting some upward pressure on inflation.

However, the bank said a myriad other factors are putting downward pressures on prices. The banks said credit market problems and anticipated losses on U.S. sub-prime mortgages have worsened since mid-October, and are expected to persist.

"There is an increased risk to the prospects for demand for Canadian exports as the outlook for the U.S. economy, and in particular the U.S. housing sector, has weakened," the bank added.

"The central bank realized that the currency strength, alongside
the intensifying economic slowdown in the U.S., and the financial
difficulties associated with the subprime mess, were all spilling
over into Canada," said Scotiabank's deputy chief economist, Aron Gampel.

The interest rate decision had been hotly debated by economists, with a close split between those who expected a cut Tuesday and those who expected the bank to cut on its next scheduled decision date of Jan. 22.

Further rate cuts possible: analysts

Some analysts said the central bank has given itself room to cut rates next month too. "The communiqué accompanying today's decision also leaves the door open for a further quarter-point cut on Jan. 22, as the bank did not provide its past mantra that it 'judges that the current level of the target rate to be appropriate'," said TD Bank's deputy chief economist Craig Alexander.

RBC senior economist Dawn Desjardins also thinks another rate cut is likely. "Our view that Canada’s economy, like its U.S. counterpart, is headed for a period of slower growth means that it is likely that the bank will cut the policy rate again early next year," she said in a morning commentary.

Ted Carmichael, chief economist at JP Morgan Canada, sees rate cuts at each of the next three policy meetings, leaving the overnight rate at 3.50 per cent by the summer of 2008.

"The JP Morgan forecast expects an extended period of very sluggish real GDP growth and core inflation well below the 2 per cent target," Carmichael said.

With files from the Canadian Press