Economic activity in Canada hit the brakes at the end of 2007 as growth in the United States slumped.

The economy contracted by 0.7 per cent in December, Statistics Canada reported, which was a much weaker reading than economists had been projecting. A contraction of 0.2 per cent was the consensus forecast from the private sector.

"There is no disputing the fallout of the U.S. slowdown on Canada anymore," said TD Bank deputy chief economist Craig Alexander.

The Canadian dollar slipped 0.74 of a cent to end the day at $1.0132 US.

Output from Canada's beleaguered manufacturing sector tumbled by 3.2 per cent in December, reaching its lowest level since December 2001, Statistics Canada said.

Motor vehicle production dropped 27 per cent, the largest monthly decline since production cutbacks in January 1990. Extended holiday shutdowns related to inventory control and retooling for new models were the main reason for December's big decline.

Output of wood products, machinery and non-metallic mineral product manufacturing also contracted in December.

Outside of the manufacturing sector, the wholesaling, and oil and gas extraction sectors showed declines during the month.

Small gains were seen in mining, excluding oil and gas, and the financial sector, while construction output was flat.

Q4 growth down

For the fourth quarter of 2007, annualized growth in the economy came in at 0.8 per cent. That was down from the three per cent annual pace seen in the third quarter.

During the October-December period, Canada's exports fell by 2.2 per cent — the first decline in six quarters — on the rising Canadian dollar and extended holiday shutdowns in several motor vehicle manufacturing facilities.

Strong growth in consumer demand and an accumulation of wholesale and retail inventories drove imports up 2.6 per cent.

Output of the service industries grew by 0.7 per cent in the fourth quarter, while the goods-producing industries contracted 0.9 per cent.

In the United States, the fourth-quarter growth rate was 0.6 per cent.

For all of 2007, Canada's economic output increased by 2.7 per cent.

Central bank in spotlight

Eyes will turn now to the Bank of Canada, which is set to make a decision on interest rates on Tuesday.

"The low-side surprise in growth and the steep drop in December further ramps up the pressure on the Bank of Canada to cut aggressively tomorrow," said BMO Capital Markets economist Doug Porter.

Many observers expect the central bank will drop its key lending rate by half a percentage point, although some are pointing to strong domestic demand figures to argue that a quarter-point drop would be sufficient.

"The report does reinforce the notion that softening U.S. growth coupled with the lofty Canadian dollar is hurting the export sector," said Royal Bank economist Rishi Sondhi, "Against this backdrop, we see the Bank of Canada cutting the overnight rate by 50 basis points at tomorrow’s meeting."

In its most recent decision, on Jan. 22, the central bank cut its key overnight 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. It was the second cut in a month and brought the target for the central bank's key interest rate to its lowest level in 20 months.

The bank said in January that additional rate cuts were likely soon.