Robert Spector
The Bank of Canada (BoC) surprised markets with a 25-basis-point rate cut on 21 January, lowering the key policy rate to 0.75%. The overnight rate target had been at 1% since 2010.
As we read the policy statement, the BoC appears to be taking out pre-emptive insurance against downside growth risks associated with the plunge in energy prices. A net energy producer and exporter, Canada will likely see slower economic growth in 2015 when falling oil prices hit production, capital spending and employment in oil-producing regions. The rate cut is designed to cushion other regions against any contagion from oil price weakness.
Canada also faces a large hit to its terms of trade, which means that domestic income suffers — affecting consumers and companies in sectors related to energy, as well as government revenues. The rate cut is an attempt to counter this income hit with added stimulus.
Similar to many other central banks, the BoC has an inflation mandate. The decline in oil prices — and the weaker growth associated with that decline — pushed out the time when the BoC could expect inflation to return to its 2% target.
Not surprisingly, market interest rates fell on the announcement and the yield curve steepened. Lower market rates should imply lower borrowing rates for Canadians. We think the policy move was also designed to weaken the Canadian dollar further. A weaker currency could help mitigate some of the commodity price weakness and boost non-energy exports, which would support growth. In our view, the combination of lower policy rates, lower bond yields and a weaker dollar suggests that overall financial conditions have eased meaningfully in Canada after this action.
The BoC is the latest central bank to surprise markets recently with a policy move — the Swiss National Bank was the first — and joins India and Denmark in the early-2015 rate-cutting club. On 22 January, the European Central Bank is expected to add monetary stimulus to the eurozone via quantitative easing.
These actions confirm to us that in a desynchronised global growth environment with excess capacity and weak demand, central banks will only achieve already-low growth forecasts by continuously injecting stimulus.
Like Canada, Norway is facing a negative terms-of-trade event, with downside growth and inflation risks. Given its location in Scandinavia and links to Europe, Norway is also impacted by slower regional growth.
The BoC’s move is hardly without risks. By focusing on growth and inflation, the rate cut could restimulate the credit boom that the BoC was hoping to deflate. This latest action is yet another sign that the current generation of central bankers would rather keep policy easier for longer than face the risks associated with tightening too soon. The issue is that easy money may worsen imbalances over time and risk financial instability.
Robert Spector is an institutional portfolio manager at MFS Investment Management
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