Bank of Canada slashes interest rates

Forget the talk that Canada's economy can thrive without help from U.S. consumers.

The Bank of Canada muted that debate yesterday by taking a rare half-percentage-point swipe at its benchmark lending rate that left the cost of overnight loans between commercial banks at 3.5 per cent, the lowest in two years.

In making the decision, Governor Mark Carney and his five deputies on the policy-setting Governing Council ignored signs of a thriving domestic economy, including the lowest unemployment rate in three decades.

Their focus was squarely on the deteriorating U.S. economy, which is on the brink of recession amid a collapse in housing prices and tighter credit markets.

The message: There's no way Canada's 33 million people can offset weaker demand from the country's largest trading partner.

"I'm not buying the decoupling story, and the bank is not buying it either," Laurentian Bank Securities' Sébastien Lavoie, a former economist at the Bank of Canada, said from Montreal.

"We're at the mercy of what's going on in the U.S."

Canada's central bank last slashed borrowing costs by a half point in the wake of the Sept. 11, 2001, terrorist attacks.

That was before Canada emerged as an energy power and emerging economies such as China started bidding up the price of wheat and other commodities.

Over the past year, the wealth generated by record commodity prices led a growing number of economists to suggest that the country's economy might be shielded from a slowdown in the United States.

Many analysts, including HSBC's Stewart Hall, were predicting a milder quarter-point reduction yesterday, citing personal spending that accelerated 1.8 per cent in the fourth quarter and wages that grew more than 6 per cent in each of the past two years.

Mr. Carney, leading his first policy discussions since taking over from David Dodge last month, adopted the more traditional view of Canada's export-driven economy.

Canada's gross domestic product grew at an annual rate of 0.8 per cent in the fourth quarter, the slowest in 41/2 years, as exports declined for the first time in 11/2 years.

The U.S. economy, which consumes some 80 per cent of Canada's exports, was even weaker in the fourth quarter, advancing at a 0.6-per-cent annual rate.

Faced with that, not only did policy makers ensure money would be cheaper immediately, they said they would likely reduce interest rates again at their next meeting on April 22.

"There are clear signs the U.S. economy is likely to experience a deeper and more prolonged slowdown than had been projected in January," the central bank said in the statement. "These developments suggest that important downside risks to Canada's economic outlook that were identified in [January] are materializing and, in some respects, intensifying."

Mr. Carney is unique among the world's leading central bankers in choosing to follow the lead of Federal Reserve chairman Ben Bernanke, who has carved the U.S. benchmark rate to 3 per cent from 4.75 per cent since October and is expected to cut it again in March.

The Bank of England, the European Central Bank and the Bank of Japan will likely leave borrowing costs unchanged at meetings this week, according to economists surveyed by Bloomberg News.

Australia's central bank raised its benchmark interest rate a quarter point yesterday to 7.25 per cent in order to cool the fastest price increases in 12 years.

The Fed's cuts likely played a role in the Bank of Canada's move. The gap between the U.S. and Canadian rates had widened to the largest since 2004 before yesterday's decision, making Canadian interest-bearing assets more attractive and fuelling demand for the currency.

A stronger dollar only makes selling goods in the U.S. more difficult.

"The dominant theme is that Canada cannot escape the fallout from the U.S. economic slump, which has contributed to the strength in the Canadian dollar and has led to weaker demand for Canadian exports," said Craig Alexander, deputy chief economist at Toronto-Dominion Bank.

(prepared by KEVIN CARMICHAEL/Globe and Mail)