Bank of Canada Preview

December 8, 2008

The Bank of Canada will not cut its 2.25% interest rate by less than 50 basis points, and I believe monetary officials are more likely to cut rates by more than 50 basis points than by only that amount.

Relative to what the Fed has done in reducing target interest rates, the Bank of Canada fell behind the curve. It makes sense for the Fed to have cut rates more deeply than the Bank of Canada but not as much so as we’ve seen. In mid-2007, the Fed funds rate of 5.25% was 100 basis points above the Bank of Canada’s 4.25% target rate for ovenight money, and high commodity prices favored Canada over the United States. From the start, the slowdown in GDP growth was more impressive in Canada (+2.3% saar in 3Q07 followed by -0.6% in 1Q08 and +0.6% in 2Q08) than the United States, but Canada’s labor market exhibited greater resilience than its U.S. counterpart. While the Fed implemented 100 basis points of cuts in the second half of 2007, the Canadian target was raised 25 bps in July and reduced that same amount in December for a net change of zero. The Bank of Canada eased 25 basis points in January 2008, while the Fed cut by 125 basis points, raising its net incremental easing relative to the Bank of Canada to 200 basis points. The two central banks each eased by a total of 100 basis points in March-April and then did nothing further through the end of the third quarter of this year. In October, the Fed eased by another 100 basis points, whereas the Bank of Canada, also acting in two steps that month, eased by 75 basis points. Neither central bank has cut rates since October, so in all the Fed has cut rates by 425 basis points, 225 bps more than the Bank of Canada has done.

Canada’s labor market deteriorated sharply in November, when 70,600 jobs were lost, the worst monthly drop since mid-1982 and comparable in percentage terms to a decline in U.S. nonfarm payrolls of 561K, bigger than the U.S. drop last month of 533K. This slump seems genuine. The labor component of Canada’s IVEY-PMI had a sub-50 reading in November for a third consecutive month and an overall score last month of 40.2 compared to 58.7 in November 2007, 52.8 in November 2006, 65.8 in November 2005 and 58.7 in November 2004 for this key, albeit non-seasonally adjusted, snapshot of conditions and expectations in Canadian manufacturing and services. In October, Canadian building permits sank 15.7%, and personal bankruptcies rose by 7.5%, and an 18% drop in housing starts, the greatest monthly decrease in seven years, was reported earlier today. Real GDP in the fourth quarter of this year will do much worse than the dip of 0.4% that Bank of Canada officials assumed in the October semi-annual Monetary Policy Report. Commodity prices, which were a source of relative insulation to Canada vis-a-vis the United States until mid-2008, have now swung around 180 degrees to become a source of relative weakness.

There is very bad news on the political front. Prime Minister Harper suspended parliament until January 26th in order to avoid a possible vote of no confidence against his minority government today. Beyond the negative effect on consumer and business confidence of this constitutional crisis, the action puts fiscal policy on the sidelines as other governments are scrambling to deficit-spend more heavily. If I were a policymaker at the Bank of Canada, I would recommend a rate cut of a full percentage point. In terms of consequences of making a mistake, the risk of a 100-bp cut being too great and perhaps inflationary seems less significant than the risk of doing too little at this juncture.



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