Bank Of Canada Not Done In Cutting Rates

The Bank of Canada cut the overnight rate, the morning of January 22, 2008, by a quarter-point to 4.00%. According to a TD Economics Commentary, this was broadly in line with market expectations; however speculation was building in the days leading up to the meeting that the Bank might be more aggressive given that financial market confidence had been severely undermined by the prospects of a U.S. recession and the possibility of some contagion to the global economy. Speculation of a more aggressive Bank of Canada decision climaxed when the Federal Reserve caught financial markets completely off guard this morning with an inter-meeting cut of 75 basis points. Nevertheless, the Bank stuck to their guns with a more measured approach, reflecting their view that domestic demand on this side of the border is expected to remain strong. However, the Bank made it quite clear in the morning’s communication that they are prepared to deliver more rate cuts down the road when they stated that “further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance and to return inflation to target over the medium term”.

The prevailing thoughts now among economists are that the next move on March 4th will be a more aggressive 50 basis point cut. That rate decision will probably not be the result of declining domestic demand. So far, the domestic side of the Canadian economy appears well grounded. In today’s communiqué, the Bank noted that "despite tighter credit conditions, strength in domestic demand is expected to remain supported by continued income growth associated with the increase in commodity prices since October, which has led to further gains in our terms of trade.” It is also important to remember that unlike their American counterparts, Canadians are not getting hit on both ends of their asset portfolios. Home prices remain on the upswing in most major urban centers, and there is little concern that the Canadian housing market will start to mirror the slump in the U.S. In fact, it is believed that national home prices will rise at a rate of 5-7% in 2008, compared to a U.S. market that will likely absorb losses of around 5% or more.

However, it is generally believed that by the next meeting, data on the U.S. economy will show clear signs of a sharp economic slowdown. Given that inflationary pressures remain strong, a 50 basis point cut would provide insurance against the degree to which a U.S. economic downturn would affect the Canadian economy. Certainly, inflation will not provide a barrier to a more aggressive Bank of Canada. The central bank has indicated that increased competitive pressures in the retail sector and the one percentage point GST cut at the start of the year will cause both core and total CPI inflation to fall below 1.5% by the middle of this year before returning to their 2% target by the end of 2009.

Following the March 4th meeting, there could possibly be another 25 basis point cut. However, because there is so much economic uncertainty on both sides of the border, the degree of additional rate cuts will depend on how events in the U.S. unfold and whether financial market confidence is still question.