Bank of Canada Selects the More Cautious Option

October 21, 2008

The Bank of Canada rate target was cut for the second time this month but by 25 basis points this time. Some analysts, including myself, were anticipating a bolder 50-bp cut to match the action taken on October 8th. The new overnight target of 2.25% has a 75-bp premium relative to the Federal funds rate, and that will widen to at least a full percentage point after the FOMC meets on October 28-29th. A statement released by central bank officials revised projected inflation “significantly” lower. The new forecast claims that total inflation has already peaked, will fall to less than 1.0% by mid-2009 and later only return to target (2%) by end-2010. Core inflation will run below 2% all of next year and also all of 2010. Deflated by the new price forecast, the 2.25% nominal rate target implies a real central bank rate of around 1.25%.  The Fed funds target of 1.5%, in contrast, translates to an inflation-adjusted negative cost of around 1.0% and will be sliced to even lower by the end of this month.

During a recession, especially one caused by a global financial crisis that can spawn deflation and already has commodity costs sinking rapidly, it is appropriate and preferable for central banks to permit their benchmarks to sink below expected inflation. The Fed has done this. The Bank of Canada has not, even thought the new statement by officials projects average real growth in 2008 and 2009 of just 0.6% apiece and concedes a “more uncertain than usual” outlook. Bank of Canada officials have confidence in the support of resilient emerging markets and the effectiveness of “extraordinary measures to stabilize financial systems” being taken in the major economies. Above-trend growth of 3.4% is predicted for 2010 in response to “improved credit conditions, the lagged effects of monetary policy actions, and stronger global growth.” Most telling, Canadian officials are predicting only a “mild” global recession ahead, a characterization that contradicts the claim of many analysts that this will be the worst slowdown since the Great Depression.

The Bank of Canada’s caution likely embodies two other considerations. One is the sizable 25% depreciation of the Canadian dollar from its high of last November, which today’s statement explicitly notes should offset weaker global demand and an eroding terms of trade. The second factor is a desire to retain the flexibility to ease in the future should conditions warrant. The statement in fact asserts that “some further monetary stimulus will likely be required to achieve the 2% inflation target over the medium term.”  A cut from 3.0% to 2.25% within the confines of a single calendar month represents a 25% reduction in the cost of funds, which is more than the 14.3% drop in Australia resulting from a benchmark rate cut to 6% from 7% done earlier this month. Officials would probably argue that such exceeds a threshold that demonstrably proves the central bank can act decisively when faced with an emergency. The danger of such logic is that since officials seem convinced that more easing will be necessary down the road, the damage will be greater from today’s reduction if a 50-bp move would have been a more correct increment than would have been the case should officials have eased by 50 basis points today in a situation where hindsight  shows that a 25-bp cut would have sufficed and been better.

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