Bank of Canada not done in cutting rates

The Bank of Canada cut the overnight rate this morning
by a quarter-point to 4.00%. This was broadly in line
with market expectations; however speculation was building
in the days leading up the meeting that the Bank might
be more aggressive given that financial market confidence
had been severely undermined by the prospects of a U.S.
recession and the possibility of some contagion to the global
economy. Speculation of a more aggressive Bank of
Canada decision climaxed when the Federal Reserve
caught financial markets completely off guard this morning
with an inter-meeting cut of 75 basis points. Nevertheless,
the Bank stuck to their guns with a more measured
approach, reflecting their view that domestic demand on
this side of the border is expected to remain strong. However,
the Bank made it quite clear in this morning’s communication
that they are prepared to deliver more rate cuts
down the road when they stated that “further monetary
stimulus is likely to be required in the near term to keep
aggregate supply and demand in balance and to return inflation
to target over the medium term”.
We believe the next move on March 4th will be a more
aggressive 50 basis point cut. That rate decision will probably
not be the result of slumping domestic demand. So
far, the domestic side of the Canadian economy appears
well grounded. In today’s communiqué, the Bank noted
that despite tighter credit conditions, strength in domestic
demand is expected to remain supported by continued income
growth associated with the increase in commodity
prices since October, which has led to further gains in our
terms of trade.” It is also important to remember that
unlike their American counterparts, Canadians are not get-
ting hit on both ends of their asset portfolios. Home prices
remain on the upswing in most major urban centers, and
there is little concern that the Canadian housing market
will start to mirror the slump in the U.S. In fact, we believe
national home prices will rise at a rate of 5-7% in
2008, compared to a U.S. market that will likely absorb
losses of around 5% or more.
However, we believe that by the next meeting, data on
the U.S. economy will provide a smoking gun, showing
clear signs of a sharp economic slowdown. Given that
inflationary pressures remain well in hand, a 50 basis point
cut would provide much-needed insurance against the degree
to which a U.S. economic downturn would lap onto
Canadian shores. Certainly, inflation will not provide a
barrier to a more aggressive Bank of Canada. The central
bank has indicated that increased competitive pressures in
the retail sector and the one percentage point GST cut at
the start of the year will cause both core and total CPI
inflation to fall below 1.5% by the middle of this year before
returning to their 2% target by the end of 2009.
Following the March 4th meeting, there is the potential
for another 25 basis point cut. However, given the degree
of economic uncertainty on both sides of the border, the
extent of additional easing will be highly dependent on how
developments in the U.S. unfold and whether financial
market confidence remains in question.
Some of the guessing on the Bank’s views will be answered
on Thursday when they release the update to the
Monetary Policy Report (10:30ET). This report will lay
out the Bank’s downgraded views on Canadian and American
economic growth alongside a more detailed assessment
of the current economic and financial environment.

(prepared by Beata Caranci, Director of Economic Forecating/TD Bank Financial Group)