The Bank of Canada on Tuesday cut its key lending rate by a quarter of a percentage point to four per cent in a bid to keep the effects of a U.S. slowdown from spilling over into Canada.

A cut of that size was in line with what was expected by the markets. It was the second cut in a month and brings the target for the central bank's key interest rate to its lowest level in 20 months.

The Bank of Canada signalled that additional rate cuts were likely soon.

"Further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance and to return inflation to target over the medium term," the bank said in a statement.

Dawn Desjardins, a senior economist at Royal Bank, said Tuesday's Bank of Canada announcement points to additional rate cuts ahead, especially if the U.S. economy remains under downward pressure.

"Our baseline forecast is that the [Bank of Canada] will lower the overnight rate by another 50 basis points during the next couple of meetings with the risk of more aggressive rate cuts if the U.S. situation continues to deteriorate," she said.

The central bank said it projects weaker growth in 2008 than it had expected in October. It also lowered its inflation projections. The bank sees core and total CPI inflation to both fall below 1.5 per cent by the middle of this year before returning to the two per cent target by the end of 2009.

The Bank of Canada said the 2008 outlook for the U.S. economy is now "significantly weaker" than it was when the bank issued its last monetary policy report in October.

"For Canada, the effects of the weaker U.S. economic outlook will lead to additional downward pressure on export growth," it said, but added that domestic demand in Canada is likely to "remain strong," despite the problems in global credit markets.

Prime rate drops to 5.75%

Prime lending rates quickly began dropping at the banks. Royal Bank was the first to announce it would lower its prime rate by a quarter of a percentage point to 5.75 per cent. TD Bank, CIBC and Scotiabank followed soon after. The prime rate is the rate banks charge on loans to their best customers.

There was speculation last week that the banks might not follow through on a Bank of Canada rate cut with a prime rate cut of their own to compensate for the increased costs they face in raising money in the financial markets.

But with prime rates dropping, consumers can look forward to cheaper variable-rate mortgages, lines of credit, and other floating rate loans.

Less than an hour before the Bank of Canada announced its rate cut, the U.S. Federal Reserve surprised markets with an unscheduled slashing of its key lending rate. The Fed chopped the overnight rate by three-quarters of a percentage point to 3.5 per cent.

"There's clearly weakness in the global economy and the [Bank of Canada] is clearly worried that there's going to be weakness in the Canadian economy to follow through, given the amount of export trade that Canada does," said Dennis Gartman, publisher of the widely followed Gartman Letter.

The Bank of Canada's more modest rate cut explains the Canadian dollar's move higher. The loonie was up almost half a cent to a close of 97.27 cents US.

Barring an unforeseen interest rate announcement in the next week, this was the last policy-setting decision presided over by David Dodge. After seven years at the helm of the Bank of Canada, he will be replaced at the end of the month by Mark Carney.