Surprise rate cut lesser of evils

It's a rare day indeed when the Bank of Canada delivers a surprise interest-rate cut and financial shares take a dive. Fear of further subprime rot, apparently, continues to outweigh the prospect of lower costs and more attractive dividend returns.

Rot was firmly in the bank's mind yesterday as it cut its overnight target rate to 4.25% from 4.50%, opening what could be a wider and deeper front in the defence against the global credit crunch.

The Bank of England may also cut rates tomorrow; the drumbeat for lower European Central Bank rates grows ever louder; and a 50-basis-point reduction from the U.S. Federal Reserve next week is now a possibility.

The fact that a cut may cool the European currencies, as it did forcefully for the loonie yesterday, pushing it down US1.20¢ to US98.78¢, may be a temptation too hard to resist.

"This did send a shock in the financial community, particularly in the foreign-exchange community here, because it said the G7 is open and willing to cut rates, even if inflation remains a concern," said Michael Woolfolk, senior currency strategist at Bank of New York.

"[The] Bank of Canada, and perhaps others, are willing to take the lesser of two evils. They're willing to cut interest rates and tempting threats to price stability, perhaps fanning the flames of inflation, in order to maintain orderly market conditions and maintain market confidence."

In its statement yesterday, the bank said "upside risks to the bank's inflation projection remain," given strong domestic demand and weak productivity growth.

But downside risks have increased, it added.

"Global financial-market difficulties related to the valuation of structured products and anticipated losses on U.S. subprime mortgages have worsened since mid-October, and are expected to persist for a longer period of time," the bank said.

"In these circumstances, bank funding costs have increased globally and in Canada, and credit conditions have tightened further."

There was further evidence of that, particularly in Europe, yesterday as interbank lending rates rose to multi-year highs and European and U.S. officials said easing the global credit squeeze would be long and slow.

Canadian dollar rates were fixed at 5.06% in London before the rate cut, up 36 basis points since mid-November, when credit fears intensified.

"As we head into year-end, we are witnessing a resurgence of risk aversion and continued impaired liquidity across the credit spectrum," Anthony Ryan, Assistant U.S. Treasury Secretary for Financial Matters, said at a conference in Paris.

"This may put a question mark over our hopes that Europe could 'decouple' its cyclical evolution from the evolution of financial markets and certainties in the U.S. outlook," added Christian Noyer, a member of the European Central Bank's governing council.

Of course, the Bank of Canada had complete cover for yesterday's cut: Inflation has significantly receded. Total and core inflation, at 2.4% and 1.8%, respectively, in October, were below the Bank's expectations, "reflecting increased competitive pressures related to the level of the Canadian dollar," the bank said.

Retail price cuts in response to the loonie's charge over par are obviously having an impact on inflation in the bank's thinking.

It added it expects inflation over the next several months to be lower than was projected in its October monetary policy report. Furthermore, there is an increased risk to Canadian exports as the outlook for the U.S. economy weakened, the bank said.

The BOE may have a similar luxury to cut with consumer price inflation comfortably below 3% but the famously inflation-averse ECB may not. Inflation in the eurozone has hit 3.0%.

Still, "the BOE and ECB could just as easily surprise markets on Thursday with 25 basis points rate cuts of their own," Mr. Woolfolk said.

Most economists now see the bank cutting again at its January announcement, though many expect this to be a mild rate-cutting cycle with just a couple of cuts next year.

Then again, a week or two ago few were forecasting a 50-basis-point cut from the Fed next week; now it appears firmly on the table.

(prepared by Jacqueline Thorpe/Financial Post)