BoC cuts rate to all-time low

As expected, the Bank of Canada cut its overnight lending rate by half a percentage point on Tuesday to 0.5% — the lowest rate on record.

The rate cut comes amid a wave of similar rate cuts by global banks across the world as the global economy contracts severely.

“The outlook for the global economy has continued to deteriorate since the Bank’s January Monetary Policy Report Update, with weaker-than-expected activity in major economies. The nature of the U.S. recession, with very weak auto and housing sectors, is particularly challenging for Canada,” the BoC wrote in its announcement. “Stabilization of the global financial system remains a precondition for the global and Canadian economic recoveries. The timely implementation of ambitious plans in some major countries to address toxic assets and recapitalize financial institutions will be critical in this regard.”

The news is troubling because the BoC had already downgraded its forecasts in January, when it released a sombre outlook for the Canadian economy. Less than a month and a half later, it’s ramping up concern even further.

“National accounts data for the fourth quarter of 2008 and other indicators of aggregate demand point to a sharper decline in Canadian economic activity and a larger output gap through the first half of 2009 than projected in January. Potential delays in stabilizing the global financial system, along with larger-than-anticipated confidence and wealth effects on domestic demand, could mean that the output gap will not begin to close until early 2010,” the BoC writes.

The bank has not abandoned its outlook that things will improve by 2010. The BoC believes the “aggressive” fiscal policy actions in Canada and other major economies will begin to be felt in the second half of 2009 and gain momentum through 2010.

The BoC has cut the overnight rate by 400 basis points since December 2007, an action it believes has allowed it to target the total CPI inflation to 2%. The Bank emphasizes that the target for the overnight rate can be expected to remain at this level or lower at least until there are “clear signs that excess supply in the economy is being taken up.”

When could that be? The BoC likely doesn’t know. Paul Ferley, assistant chief economist at RBC Economics Research, pointed out in his report yesterday that the Canadian economy’s fourth contraction of 3.4% — announced yesterday by Statistics Canada — far outstripped the Bank’s expectations.

“The decline in Q4 GDP was well in excess of the 2.3% drop projected by the Bank of Canada in its January Monetary Policy Report Update. They had suggested that the first quarter might even show a greater decline of 4.8%, which does allow the central bank to argue that the weakness in growth may be hitting the economy sooner than anticipated,” Ferley says. “However, the steady decline in monthly growth through the fourth quarter suggests little indication that the pace of decline is poised to reverse going into 2009.”

Douglas Porter, BMO’s deputy chief economist, believes the economic contraction is only getting revved up.

“Even with the sharp decline in Q4 GDP, the current quarter is expected to show an even deeper setback. Canada’s recession began in earnest early in Q4,” Porter writes in his latest report. “The big drop in the Q4 trade surplus was due to lower export prices, and that drove a massive 10.3% drop in GDP prices, the biggest on record. On a monthly basis, real GDP fell 1.0% in December, on top of a 0.7% drop in November and the fifth consecutive monthly decline. With the weak hand-off, and based on early results from the current quarter, we now expect GDP to drop at roughly a 6% annualized return in Q1 (of 2009), challenging 1991 Q1 (-5.9%) for the weakest quarterly performance in data back to 1961.”

TD Economics has a similar forecast, expecting a contraction in excess of 5% for the first quarter of 2009. However, economist Diana Petramala points out Canada is in better shape than many of its industrialized peers.

“While the Canadian economy succumbed to the global pressures in the last quarter of 2008, it still remains amongst the best-performing countries across the globe, and managed to outstrip a 6.2% decline in the U.S,” she says. “However, the fourth quarter marks just the beginning of Canada’s recession. As producers attempt to correct for the unintended inventory buildup, and as falling income puts further downward pressure on the domestic economy, we expect at least a 5% decline in the first quarter of 2009, to lead an overall annual decline of 2.2% in 2009.”

(03/03/09)