Rate cuts herald deeper financial downturn

Canadian banks cut interest rates dramatically yesterday after the Bank of Canada slashed its main rate by half a percentage point and warned that a serious economic slowdown was only just beginning.

All major banks cut their prime lending rate by 50 basis points, amid a central bank warning that Canada faces a tough two years. A troubled U.S. economy has hit exports hard, and undermined business and consumer confidence, the bank said.

Marking the most serious cuts since the post-9/11 downturn, the bank has now cut rates twice in six weeks. Its key rate now stands at 3 per cent, 150 basis points lower than where it stood last fall. (A basis point is one one-hundredth of a percentage point.)

"The bank is now projecting a deeper and more protracted slowdown in the U.S. economy," it said in a release. "This has direct consequences for the Canadian economic outlook, with declining exports projected to exert a significant drag on growth in 2008."

The Canadian dollar slumped almost three-quarters of a cent in reaction, but recovered most of those losses after the price of oil surged to a new record. The loonie closed at 99.21 cents U.S., down 0.19 cents.

The central bank's new forecast puts real growth at just 1.4 per cent this year and 2.4 per cent in 2009. In January, the bank was forecasting 1.8 per cent growth in 2008, and last October, it believed Canada would bypass the U.S. slump and see the economy grow by 2.3 per cent this year.

Despite the aggressive central bank action, the biggest commercial banks were slow to react, and there was little sign late yesterday of serious interest-rate cuts at the consumer level.

Several hours of foot-dragging by the chartered banks raised concerns about the central bank's effectiveness and whether the commercial banks are more concerned about growing credit risks.

The Toronto-Dominion Bank was first to act, just after 5 p.m., nearly seven hours after the central bank made its move. TD announced a 50-basis-point cut to its prime lending rate, to 4.75 per cent. The other four big Canadian banks followed suit.

Several economists warned that aggressive rate cuts and heightened attention to the U.S. deterioration are not enough to turn around the Canadian economy. They said the central bank also needs to target intensifying liquidity problems for banks and their biggest borrowers.

"We're in need, not only of macroeconomic stimulus, but we're also in need of financial stability," said Dale Orr, chief economist of Global Insight Canada.

The central bank emphasized that the slowdown and the credit crunch will not dissipate easily or quickly.

Canada will not see a full recovery until 2010, when it is expected to rebound with 3.3 per cent growth as the United States gradually emerges from its funk and credit conditions return to normal, the bank projected.

At the same time, the central bank appears to be re-evaluating the pain caused by the global credit crunch, pointing out in its statement that credit conditions are tighter, and along with crumbling confidence, will cut into business and consumer activity in Canada.

"While the latest statistics have underscored a resurgent strength in Canadian home construction, manufacturing and international trade, the bank is looking past these red herrings and has its sights set squarely on the formidable risks looming over the horizon," commented Richard Kelly, senior economist at TD.

The tone of the central bank's statement, however, suggested to many economists that 50-point cuts have come to an end, and further cuts will be smaller and perhaps less frequent.

"While we still look for another modest trim in rates at the next decision date in June, that may be the end of the line for rate cuts, especially if credit conditions begin to stabilize," said Doug Porter, deputy chief economist at BMO Nesbitt Burns.

Borrowers and lenders are not the only ones feeling the pain of the U.S. slump.

The central bank warned that Canada's exports are plunging, and the U.S. slowdown is now expected to be "deeper and more protracted" than the bank believed previously.

Indeed, Export Development Canada yesterday said exports would drop by 3.5 per cent this year, in real terms. Excluding energy and agrifoods, real exports are expected to drop almost 7 per cent, with consumer goods and the auto sector taking the biggest hits.

Tightening credit conditions and crumbling confidence also mean that business investment and consumer spending will weaken in Canada, the bank warned.

Still, domestic demand is strong, and likely will remain that way, fuelled by "firm" commodity prices, a robust job market and monetary stimulus, the bank said.

It indicated it will continue to cut rates in the future, but probably not as aggressively as in the past few months.

The bank noted that both total inflation and core inflation (which excludes the most volatile items such as energy and some types of food) are running lower than its target of 2 per cent. A weaker economy will keep inflation below the target through this year and next, moving back to the target in 2010.

The bank's next announcement for the target rate is scheduled for June 10. Many economists expect it will make its last adjustment this year by shaving the overnight rate to 2.75 per cent.

2007 2008
Canada 4.25% 3%
United States 5.25% 2.25%
Europe 3.83% 3.877%
Britain 5.2813% 5.035%
Iceland 14.25% 15.5%
Japan 0.75% 0.75%
China 3.24% 4.32%
Brazil 12.5% 11.75%

(prepared by Heather Scoffield/Globe & Mail)