INTEREST RATES: Further cut anticipated

Bank of Canada Governor Mark Carney is approaching uncharted territory.

Widely expected to reduce the benchmark lending rate to 0.5 per cent this week, Mr. Carney and his advisers on the governing council have reached the point where they must consider more radical measures to a fight a recession that shows little sign of letting up.

"We're sitting at a pretty key point," said Doug Peters, former chief economist at Toronto-Dominion Bank and a junior finance minister under prime minister Jean Chrétien. "I don't think the policy makers know exactly where we are at the moment."

The Bank of Canada's key interest rate, the target for overnight loans between banks, sits at 1 per cent after a half-point reduction on Jan. 20.

Most economists expect the central bank to cut the overnight target another half-point tomorrow, because economic indicators remain grim.

United States economy contracted 6.2 per cent in the fourth quarter, the most since 1982, and Statistics Canada is set to add to the misery today with a report that will show Canada's gross domestic product shrank 3.5 per cent in the final three months of 2008, according to the consensus estimate of Bay Street analysts.

The question, then, is what Mr. Carney intends to do if rock-bottom interest rates continue to fail to spark economic growth? So far, he's declined to say, arguing that to do so before the time was right would only confuse markets.

That time likely has arrived.

If Mr. Carney does what's expected, he effectively will have exhausted conventional means of boosting the economy.

Mr. Carney will have reached the end of those conventional means because the benchmark interest rate will be so close to zero.

Reducing the overnight target to less than 0.5 per cent risks disrupting markets for short-term paper and other financial products because prices are based on the official rate, according to Charmaine Buskas, senior economics strategist at TD Securities.

Given those concerns, Mr. Carney will be under pressure to address whether he is considering a move to "quantitative easing," a strategy that would see the central bank increase the money supply by using its reserves to buy debt or other assets.

"It's the only thing that's left," said Stephen Gordon, an economics professor at Laval University in Quebec City. "If the issue is deflation, you have to create money, and the instruments available before are no longer available."

Both the U.S. Federal Reserve and the Bank of England have said this year that they might buy government debt to lower market interest rates, and the Bank of Japan already is adding corporate bonds to its balance sheet.

Market conditions in the U.S., Britain and Japan are far more severe than in Canada, allowing Mr. Carney to take a more cautious approach to easing the credit crunch.

Like other major central banks, the Bank of Canada is auctioning short-term loans to banks and accepting as collateral riskier assets that can't be sold privately.


Last week, the Bank of Canada said it would soon accept corporate debt as collateral for some of these loans and pledged to open some of its auctions to bids from pension funds and other big players in financial markets.

The biggest risk to moving to a quantitative easing program is runaway inflation once the economy rebounds – a big concern for the Bank of Canada, which is mandated to keep inflation at about 2 per cent.

While Mr. Carney needs to "get his ducks in a row," there is little need right now to move into credit markets as aggressively as the other central banks, said Mark Chandler, an economist at Royal Bank of Canada.

A half-point cut of the overnight target rate tomorrow would be significant, and the federal government is poised to pump $40-billion into the economy, Mr. Chandler points out.

Others say the bigger risk is that deflation becomes entrenched as the economy worsens because companies can't get credit.

Mr. Peters said the central bank may have to buy assets from non-bank lenders, which once were important buyers of commercial paper and other corporate debt and are now jammed up by the financial crisis.

"In March and April, they are going to have to think about going out there to buy a significant segment of the short-term and medium-term assets of financial institutions that are in much worse shape than the banking industry," Mr. Peters said.

"You may have to have the central bank step into those areas and make substantial purchases in those areas."

(prepared by Kevin Carmichael/Globe & Mail)