The US dollar rallied against a basket of currencies after the signal by the Fed, which also said it would begin in October to reduce its roughly $4.2 trillion in holdings of US Treasury bonds and mortgage-backed securities.

"I think the market believes more in another interest rate hike (by the Fed) this December," said Hendrix Vachon, senior economist at Desjardins. "If interest rates are increasing in the US, it boosts the US dollar against other currencies."

The loonie lost ground despite a rally in oil, one of Canada's major exports.

US crude prices settled 1.9 percent higher at $50.41 a barrel after the Iraqi oil minister said the Organization of the Petroleum Exporting Countries and its partners were considering extending or deepening output cuts.

At 4 p.m. ET (2000 GMT), the Canadian dollar was trading at C$1.2329 to the greenback, or 81.11 US cents, down 0.3 percent.

The currency's strongest level of the session was C$1.2198, while it touched its weakest since Sept. 6 at C$1.2390.

The loonie had lost ground on Monday after a Bank of Canada policymaker said that the currency's strength would be a factor in future rate decisions.

The currency has gained nearly 9 percent this year against the greenback, helped by two interest rate hikes by the Bank of Canada over the past three months after the country's economic growth accelerated.

Canadian government bond prices fell across the yield curve in sympathy with US Treasuries. The two-year retreated 3.5 Canadian cents to yield 1.577 percent and the 10-year  declined 10 Canadian cents to yield 2.106 percent.

The 10-year yield revisited Monday's nearly three-year high of 2.119 percent.

Canada's August inflation report and retail sales data for July are due on Friday.