Bank of Canada cut keeps dollar dropping

The Bank of Canada on Tuesday lowered borrowing costs for the first time in more than 31/2 years, citing the negative impact of the Canadian dollar's recent dramatic rise, turmoil in financial markets that has resulted in tighter credit, and a slowdown in the U.S. economy that could hamper growth in Canada.

The central bank, which lowered its key lending rate by a quarter-point to 4.25 per cent, also said the risk of inflation had decreased marginally since October.

"All these factors considered, the bank judges that there has been a shift to the downside in the balance of risks around its October projection for inflation through 2009," it said in a statement.

The bank added that the economy "continues to operate above its production capacity."

"The Canadian economy has been growing broadly in line with the bank's expectations, reflecting in large part underlying strength in domestic demand," it said. "There is an increased risk to the prospects for demand for Canadian exports as the outlook for the U.S. economy, and in particular the U.S. housing sector, has weakened."

The economy expanded more than expected in the third quarter, growing 2.9 per cent, but still below a 3.8-per-cent advance in the second quarter. Meanwhile, core inflation was running below the bank's two-per-cent target in October -- partly due to price cuts by retailers to accommodate the high-flying Canadian dollar -- and unemployment was at a 33-year low of 5.8 per cent in October. Some economists, however, expect the jobless rate to rise to 5.9 per cent in the November report, which will be released on Friday along with U.S. employment numbers.

"What [the bank] is really saying is that it can afford to cut rates and not have inflation," said TD Financial Group deputy chief economist Craig Alexander.

The decision, however, sent the Canadian dollar tumbling. It began falling after the bank's morning announcement and ended trading on Tuesday at 98.78 cents US, down from Monday's close of 99.98 US cents. The dollar -- which rose above parity with the U.S. currency on Sept. 20 for the first time in three decades and hit a modern-day high of $1.1039 on Nov. 7 -- has been falling sharply ever since on worries that the currency had risen too far, too soon.

Tuesday's rate cut by the Bank of Canada -- which was followed quickly by prime-rate cuts by commercial banks, effective Wednesday -- marked the first time the bank has lowered borrowing costs since April 2004.

"It certainly will impact a pretty broad set of customers. Businesses will be able to borrow more easily, exporters will encounter much more favourable conditions, both at the border and in their own borrowing, and it'll even give a spurt to the consumer," Eric Lascelles, chief economics and rates strategist at TD Securities, told Reuters.

Analysts had been divided on whether the bank would keep rates on hold or cut them by a quarter-point.

"Just as important as the rate cut itself is the fact that the bank did not say anything to suggest that a long string of rate cuts is in the pipeline," said Jacqui Douglas, economics strategist at TD Securities.

"Given the recent volatility in the financial markets, it was probably wise for the Bank of Canada to keep their options open, since conditions can change very rapidly."

Still, Douglas said the Bank of Canada could chop another quarter point off its key lending rate at its Jan. 22 meeting. "But that will depend on the incoming data."

Douglas Porter, deputy chief economist at BMO Capital Markets, agreed that the bank could cut rates again next month, "although the tone of today's press release does not hint at a significant easing campaign."

"The bank is still officially concerned about upside risks to inflation -- given a very low jobless rate -- but the credit squeeze and a possible U.S. recession are the dominant concerns now," Porter said.

"As well, with core inflation now below two per cent and potentially headed lower thanks to a wave of retail price cuts in Canada, this gives the bank ample room to respond to any deepening market turmoil . . . "

Many analysts expect the U.S. Federal Reserve will continue lowering interest rates, as the economy of Canada's biggest trading partner struggles with the market fallout from the subprime-mortgage crisis. The Fed meets next week to decide on the direction of rates.

(prepared by Gordon Isfeld/Vancouver Sun)