U.S. woes hit home as Bank of Canada cuts rates

Central banks are warning that the global credit crunch is no longer a problem just for the financial markets, and is beginning to take a painful bite out of the real economy.

The Bank of Canada cut its key interest rate by a quarter of a percentage point yesterday to 4.25 per cent. It was the first interest rate cut since April, 2004 - an insurance policy to offset some of the harm that the credit crunch is posing to consumer and business activity.

The central bank pointed out that market turmoil has persisted far longer than expected, with the dual effect of a tightening of credit conditions and a slowing of U.S. demand for Canadian products.

At the same time, top U.S. officials warned that market anxiety has deepened, and a European Central Bank official said yesterday that the credit turmoil is eroding Europe's immunity to a U.S. slowdown.
"Certainly the U.S. was the first to be afflicted by this, to feel the impact," said Stewart Hall, strategist at HSBC Securities (Canada).

"You can make the case that the implications are making their way around the globe," Mr. Hall said.

Canada's central bank is the first outside the United States to take monetary policy action.

The quarter-point interest rate cut and economic assessment drove down the dollar by more than a cent yesterday, to close at 98.8 cents (U.S.).

The Bank of Canada pointed to the strong dollar, Canada's vulnerable export sector, and lower-than-expected inflation. In the past month, the bank has become increasingly pessimistic about the economy's ability to thrive with a strong currency and U.S. downturn.

It also highlighted the financial market problems in dealing with losses and repricing of securities based on U.S. subprime mortgages.

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

Interbank lending rates widened significantly after mid-August, but then settled back, only to widen again in November because banks are more wary of lending to each other.

Those higher costs are spilling over into the real economy in the form of more expensive mortgages and a growing reluctance on the part of banks to lend to anyone but the best of customers.

The Bank of Canada's last official estimate was that the credit crunch was taking the same toll on the economy as an interest rate hike of a quarter of a percentage point. That estimate is clearly too low now, economists said, and the central bank is undoubtedly revising it upward.

"I don't really think the Canadian dollar was the big driver here [for the Bank of Canada's decision to cut rates]," said Douglas Porter, deputy chief economist at BMO Nesbitt Burns. "I think it was the ongoing turmoil in financial markets and the very real risk it's morphing into a macroeconomic event."

Craig Alexander, deputy chief economist at Toronto-Dominion Bank, said it's unlikely that yesterday's rate cut will do much to resolve the credit and liquidity problems plaguing the markets. Lower rates may marginally encourage domestic consumption and business investment, but won't directly resolve the lack of trust and the risk aversion that has prompted credit to tighten in the first place, he said.

Lower rates will, however, help the Canadian economy deal with the impact of a slowing U.S. economy, economists said, and a U.S. slowdown will likely hurt Canada more than the effects of the credit crunch.

Already there are signs that the Canadian economy is cooling, even in Western Canada, said Ted Carmichael, chief economist for J.P. Morgan Securities Canada.

He believes Canada's growth will slow to a crawl for "an extended period" because of its exposure to the U.S. economy.

The Bank of Canada said the Canadian economy is still in overdrive for now, but pointed out inflation has softened considerably. In particular, the high dollar has prompted a strong reaction by retailers to cut their prices for goods sold in Canada, the bank said.

But the bank gave no indication about whether yesterday's rate cut was the first of many. Rather, it said it would reassess the data in January.

(prepared by Heather Scoffield/Globe & Mail)