Bank of Canada chops rate

The Bank of Canada has slashed its key overnight lending rate by 75 basis points, to 1.5%. The Bank rate has been adjusted accordingly to 1.75%. Many Bank watchers had been anticipating a cut of just 50 basis points.

“The outlook for the world economy has deteriorated significantly and the global recession will be broader and deeper than previously anticipated,” the Bank said in a statement. “Measures taken by major governments are beginning to encourage credit flows, although it will take some time before conditions in financial markets normalize.”

The Bank said that the Canadian economy had unfolded as expected through the summer and early fall, and admitted that it is now following the rest of the world’s economies into recession.

Household and business confidence has fallen as exports wane, making inflation less of a threat than recession. On the upside, the Canadian dollar has taken a hit from falling commodity demand, which the Bank suggests may help the struggling manufacturing sector.

“The Bank will continue to monitor carefully economic and financial developments in judging to what extent further monetary stimulus will be required to achieve the 2% inflation target over the medium term,” the Bank’s statement concluded.

Of course, there are other means to stimulate the economy, according to David Laidler, professor emeritus at the University of Western Ontario’s economics department.

Speaking to a recent breakfast symposium hosted by the Investment Funds Institute of Canada, Laidler reminded the audience that inflation reports are backward looking, and said that inflation is currently “dropping like a stone.”

“We have in place an inflation-targeting regime,” he said. “When inflation is falling below 2%, the Bank of Canada gets active and expansionary. There is lots of room for expansionary monetary policy aimed at keeping inflation up by continuing to stabilize the real economy.”

While most people equate monetary policy with the central bank’s interest rate, Laidler points out that this is only one element of monetary policy. What the economy needs now, he argued, is the issuance of new Government of Canada bonds. Financial institutions would likely snap up the new debt, attracted by the low risk.

The near risk-free nature of these assets would make them ideal collateral for loans from the central bank. Such an open-market approach would have a far greater impact on liquidity than simple rate cuts.

“Particularly in a convulsion, you need the creation of large amounts of liquidity by the central bank to keep the financial system functioning,” he explained. “The purpose of fiscal deficits in trying to manage that transition from convulsion to stagnation and into [the] improvement [stage], is to provide the government securities to the market that the central bank can then buy up to keep pushing liquidity.”

(12/09/08)