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Outlook dims as rates fall to record low

Blog by Shaun Kimmins | January 21st, 2009

OTTAWA -- The Bank of Canada has cut its key interest rate to a record low, warning of a deepening recession that is hitting the country on many fronts - a bleak picture of the Canadian economy that serves to underline the need for effective federal stimulus in Finance Minister Jim Flaherty's budget next week.

Citing the intensifying financial crisis that is "spilling over into real economic activity" around the world, the central bank drastically slashed its growth expectations for Canada this year, forecasting a contraction of 1.2 per cent, compared with an earlier forecast of a modest 0.6 per cent expansion.

The country's income is contracting, house prices are falling, wealth is crumbling and exports are on a sharp decline, the bank noted. It cut its target for the overnight lending rate by half a percentage point to 1 per cent - lower than in 1958, when the most-watched policy rate was 1.12 per cent.

The major banks matched the Bank of Canada cut, passing the full amount on to consumers by slicing their prime lending rates half a percentage point to 3 per cent. In December, when the central bank slashed its overnight rate by three-quarters of a percentage point, the banks decided to cut prime by just half a point.

Mortgage rates also tumbled.

Rates on variable mortgages, which move hand in hand with the prime rate, fell. Lenders also cut fixed mortgage rates, which had been expected to fall along with bond yields.

Rate cuts alone won't be enough to push the economy into recovery, according to economists. The bank is forecasting that by 2010, financial markets will have stabilized and a combination of steep interest rate cuts and fiscal stimulus around the world will have taken effect, enabling Canada's economy to grow at 3.8 per cent.

That forecast is beyond the wildest dreams of most economists, who are projecting a more gradual recovery starting late 2009, and reflects in part a mathematical exercise that allows the bank to satisfy its goal of bringing the economy back into balance within two years. But the odds of achieving even a more modest Canadian recovery rest heavily on the budget to be delivered in Ottawa next week.

"You've got to put on the jumper cables and give everyone a big shock," said Glen Hodgson, chief economist at the Conference Board of Canada. "The next step is a big fiscal shock. The government gets that, loud and clear."

While Mr. Flaherty has said he'll present a large stimulus plan in his budget next Tuesday, it remains to be seen how big the package will be, how quickly the money will flow into people's pockets, and how well it will be received by a dour public that is skeptical of the government's moves and is disheartened under the weight of a major global recession.

This lack of confidence is seriously harming the Canadian economy, and is "undermining business and household confidence worldwide and further eroding domestic demand," the bank said.

Fiscal stimulus needs to come swiftly and decisively, in a way that can reverse this destructive, spiralling loss of confidence that is slamming the global and Canadian economies, added Dale Orr, chief economist at IHS Global Insight Canada.

"Fears of recession cause recession," he noted. "If [Finance Minister Jim Flaherty] believes the bank, then that really puts the pressure on him to get the stimulus package working quickly."

Separately, and as if to underline the central bank's sentiments, Statistics Canada said manufacturing shipments plunged 6.4 per cent in November, the fourth consecutive month of declines.

The bank also warned that slack is building up in the economy - meaning job losses ahead. And inflation will drop to below zero for much of 2009 because of falling energy prices. Even core inflation - which excludes energy and other volatile prices - will drop to 1.1 per cent, far below the central bank's 2 per cent target.

The bank's aggressive interest rate cuts will definitely help rejuvenate growth, economists said.

But in order to change the psyche of consumers who won't spend, of businesses that resist investing and of banks reluctant to lend, the federal budget needs to back up the rate cuts with bold measures that will reassure Canadians of recovery, Mr. Hodgson said.

The budget should not only contain ways to encourage consumer and business spending, but will also likely contain measures that encourage lending and banking activity, said Avery Shenfeld, senior economist at CIBC World Markets.

"The obvious implication of being at 1 per cent is that any further reduction in borrowing costs will come from [the federal government] helping the banking system and through mortgage purchases," he said.

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