The Bank of Canada on Tuesday cut borrowing costs to a record low as it warned the economy will shrink this year.

In a further move to bolster the sagging economy, the bank reduced its key overnight rate by half a percentage point to one per cent. The bank has now trimmed 3.5 percentage points from the overnight rate since it started its latest cycle of cuts.

Tuesday's cut reduced borrowing costs below 1.12 per cent, which had been the lowest point set back in 1958.

More rate reductions may also be in the offing, as the Bank of Canada said more stimulus could be needed to boost the sagging economy.

"Major advanced economies, including Canada's, are now in recession and emerging-market economies are increasingly affected," the bank said.

"Canadian exports are down sharply, and domestic demand is shrinking as a result of declines in real income, household wealth, and consumer and business confidence."

Bank sees recovery in 2010

The Canadian economy is expected to contract by 1.2 per cent in 2009, but the bank sees a recovery in 2010, when the economy is projected to expand by 3.8 per cent.

Back in October, the bank projected growth of 0.6 per cent in 2009, and 3.4 per cent in 2010.

The bank will provide more details on its outlook for the economy on Thursday, when it releases its Monetary Policy Update.

The bank also signalled that inflation fears have abated. The so-called core inflation rate is expected to fall to 1.1 per cent in the fourth quarter of this year, while the overall inflation rate is expected to dip below zero for two quarters in 2009 because of lower energy prices.

"With inflation expectations well-anchored, total and core inflation should return to the two per cent target in the first half of 2011 as the economy returns to potential," the bank said.

Another cut predicted

Pascal Gauthier, an economist at TD Bank, is expecting the Bank of Canada will cut the overnight rate by another half percentage point to 0.5 per cent on March 3.

"Furthermore, given the considerable amount of remaining uncertainty and the fact that the Canadian recession has just started, the policy rate is expected to stay at this record low well into 2010 before inflation starts registering on the radar again," Gauthier said.

BMO Capital Markets economist Douglas Porter said that if global financial markets continue to stagger in the coming weeks, the central bank "still has the room and the willingness to cut further as the need arises."

The major Canadian banks quickly moved to reduce their prime rates to three per cent. That differed from some of the past moves by the Bank Canada, when the big banks either delayed lowering their prime rates or did not pass along the full cut.

The banks cited the tight credit markets for not passing along the cuts to customer borrowing rates.