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OTTAWA (Reuters) - The Bank of Canada cut its key overnight interest rate by one-quarter point to 4.25 percent on Tuesday, saying it expects U.S. subprime mortgage woes and financial market fallout to last longer than anticipated.
Sounding more pessimistic than it did in its last rate announcement in October, the bank said credit costs globally and in Canada have tightened and that it expects the slowing U.S. economy to suppress demand for Canadian exports. In October, the bank judged domestic borrowing costs to have tightened by 25 basis points.
The rate cut, the first since April 2004, went against expectations and prompted a sharp fall in the Canadian dollar.
But the move is likely to spur a collective sigh of relief from Canadian manufacturers and exporters, which have been calling for lower lending rates to help soften the pain caused by a strong currency.
"It certainly will impact a pretty broad set of customers. Businesses will be able to borrow more easily, exporters will encounter much more favorable conditions, both at the border and in their own borrowing, and it'll even give a spurt to the consumer," said Eric Lascelles, chief economics and rates strategist at TD Securities.
At least one bank wasted no time in following suit. Canadian Imperial Bank of Commerce immediately cut its prime lending rate to 6 percent from 6.25 percent.
A majority of Canada's primary securities dealers in a Reuters poll last week had expected the bank to keep rates steady, although most expected at least one rate cut by the end of January.
The bank's next move remains a mystery as it gave no hint of a bias for its January 22 decision, the last under Governor David Dodge, who will be replaced by Mark Carney on February 1. Nor did it suggest that it has embarked on a prolonged easing cycle.
"The bank has really promised nothing after this cut. Really, they will now be in data watching mode like the rest of us," said Doug Porter, deputy chief economist at BMO Capital Markets.
The Canadian dollar fell to C$1.0100 to the U.S. dollar, or 99 U.S. cents, from C$1.0045 to the U.S. dollar, or 99.55 U.S. cents, before the announcement. Bonds extended gains.
The bank appeared less concerned about the Canadian dollar, which has fallen from the US$1.1039 peak it hit against the U.S. dollar on November 7 to trade closer to the 98 U.S. cent level assumed in its October report.
The currency's strength helped push October inflation below the bank's forecast, and it now sees inflation remaining lower than projected over the next several months.
"All these factors considered, the bank judges that there has been a shift to the downside in the balance of risks around its October projection for inflation through 2009," it said in a statement.
In October, it said risks were "roughly balanced, with perhaps a slight tilt to the downside."
Markets were more uncertain about the bank's rate decision than they had been in some time, divided over whether it would pull the trigger and cut the rate by 25 basis points or wait until the new year.
Dodge had signaled quite clearly on Nov 17 that his outlook had soured significantly, saying the downside risks to world growth had increased in the past month.
Speculation that a rate cut was coming increased when Canada's trade surplus for September sank to its lowest since 1998.
However, a reminder that Canada's economy has been surprisingly resilient in the face of the U.S. housing downturn came last week when figures showed third-quarter economic growth, at 2.9 percent, was stronger than expected.
Indeed, the Bank of Canada still sees the economy running at above capacity and said strong domestic demand could pressure inflation, a consideration in future policy-setting.
"Given the recent volatility in the financial markets, it was probably wise for the Bank of Canada to keep their options open, since conditions can change very rapidly," said Jacqui Douglas, economics strategist at TD Securities.
Additional reporting by John McCrank in Toronto; Editing by Peter Galloway