15 JAN 2016
WILL THE BANK OF CANADA CUT RATES NEXT WEEK?
Expectations of a Bank of Canada rate cut next week are mounting and for good reason. The Canadian economy is showing signs of considerable weakness and business investment plans have been cut. Oil prices continue to decline sharply and Iranian oil supply will be coming on stream shortly. Energy companies continue to slash payrolls and dividends. Alberta’s economy will contract sharply this quarter and although the Canadian trade deficit has improved, the decline is nowhere near sufficient to offset the dampening effects of the oil rout, despite the sharp decline in the loonie.
The loonie has just posted its worst 10-day performance since it was allowed to trade freely against the U.S. dollar in 1971. Part of the reason the Canadian dollar has fallen so much is the widening prospect of a Bank of Canada rate cut on January 20–a quarter-point cut to 25 basis points, its lowest level since the 2009 financial crisis. Is this warranted? I think so. The Bank cut rates in a surprise move this time last year when the economy was newly hit by the oil price decline. Since that time, oil prices have declined dramatically further, especially for Canadian oil.
Some have argued that oil prices will remain low for an extended period and see the prospect of an initial public offering (IPO) of Saudi Arabia’s oil company, Aramco, as a sign of the end of the oil age, triggered by excess supply and international efforts to combat global warming. Saudi Arabia sees the need to diversify its economy away from oil and so should Canada.
It is not that another rate cut will have a dramatic effect on the economy–with interest rates already so low, the Bank has little ammunition left, even if they take rates into negative territory, as they suggest is possible. They might be reticent to encourage household borrowing at a time when debt levels are at record highs and the government has taken actions to slow the growth in housing. Nevertheless, some Canadian banks nudged up mortgage rates recently, and a BoC rate cut might discourage further increases and could even trigger a rollback.
Fiscal stimulus is certainly coming, but when and how is still uncertain and the economy needs all the help it can get. Market interest rates are at record lows, the stock market has fallen sharply this year, and consumers are worried as food prices continue to rise, which hurts lower-income Canadians proportionately more than others.
In addition, the Federal government has gone ahead with its high-income tax increases (as well as middle class tax cuts), which could well discourage entrepreneurs, business investment and job creation. The tax increases to levels well above those in many other countries also make it more difficult for Canadian business to attract foreign talent. The decline in the Canadian dollar, while boosting exports and foreign investment, reduces the value of the money Canadians earn and invest. The negative wealth effect damages consumer confidence.
These are difficult times for Canada and extreme measures should be taken. The Bank should cut rates and the government should introduce larger increases in infrastructure spending than were promised during the election campaign. None of Canada’s economic pain was our own doing, but counter-cyclical policy measures can and should reduce the pain as we work our way towards a more diversified economy.