On Bank of Canada’s Interest Rate Cut

Two economic events made headlines last week:
(1) Bank of Canada lowered the target for the overnight interest rate by 1/4 percentage points, to 3/4 per cent
(2) The Canadian Association of Petroleum Producers (CAPP) predicts oil producers will decrease their capital spending by 33 per cent or $23 billion in 2015

Both announcements have deep implications for the Canadian economy. How are they related?

The Bank of Canada announces the target overnight rate at eight fixed dates every year. This is the rate at which major financial institutions borrow from and lend to each other, and which typically influences other interest rates, including the prime rate.

Between February 2008 and April 2009 Bank of Canada has decreased the target overnight rate seven times from 4 per cent in February 2008 to 0.25 per cent in April 2009. Beginning in May 2010 the rate was raised again gradually, reaching 1 per cent in September 2010, and was maintained at this level for 52 months. History seems to suggest that the central bank does not take changes to the interest rate lightly.

The current projections for the Canadian economy are mixed. With the price of oil in decline, proceeds from oil exports are down, hence the abrupt decrease in investment announced by CAPP. Projects are being shelved, at least until producers get a better sense of where the oil market is going. Jobs are being slashed; the unemployment rate is on the rise. On the other hand, cheap oil and a lower exchange rate should boost the manufacturing provinces in the East. It is not clear yet what the overall effect on the Canadian economy will be, but Bank of Canada’s decision to lower the target rate indicates that they are not exactly optimistic, in particular since any changes in the target rate affect the economy with a leg.

Lower interest rates should encourage Canadians to borrow and spend, thus stimulating the aggregate demand. It would also help the real estate sector, which many were expecting to slow down this year. One quarter of a percent may not be enough to prevent a slowdown, but it may provide some cushion for a softer landing.

But all is not positive for consumers. Lower interest rates will increase the Canadian capital outflow and further depreciate the Canadian dollar, already sitting at only 0.81 U.S. dollars. Imports will become more expensive, exports will get cheaper, which will help us recover some of the lost revenues from oil exports. Canadians will pay less at the pump but will pay more on imported goods and services, and inflation may rise.

The expected increase in net exports and inflation are probably the very reason why the central bank lowered the interest rate to begin with. Before this announcement, the inflation rate (2 per cent in November 2014) was expected to decrease due to the lower price of gasoline and general economic slowdown. The ultimate goal of the Bank is to maintain a low and stable inflation rate around 2 per cent. An inflation rate that is too low and, even worse, a deflation, are not good for the economy because people might postpone major spending decisions and wait for prices to further decrease, slowing the economy. At the same time workers are reluctant to accept lower nominal wages, even if they mean the same purchasing power given the lower prices, so unemployment rises.

The interest rate cut may have an even larger impact on the economy through investment, which is known as the most volatile component of GDP. Investment pulls the rest of the economy with it in a “tail wags the dog” effect. Lower interest rates may temper some of the expected decrease in investment in the oil and gas sector, and may even increase investment and create jobs in other sectors.

We may wonder if this is a one-off move by the central bank, or if the interest rate will further be reduced and for how long. It is hard to tell at this point, and even the central bank may not have an answer yet.

One thing to keep in mind is that Canada is a small open economy, with a population smaller than California, around 11 per cent of the population of Unites States and 0.5 per cent of the World population, open to international trade and financial flows. The implication is that Canada cannot set its interest rate independently from the rest of the world for too long. Short-term departures are possible, but in the long term Canada must return to the world interest rate.

What is this world interest rate? Given our strong economic ties and geographic proximity, the U.S. interest rate is the most critical for us, although all major interest rates are important. The European Central Bank is currently in the process of decreasing the interest rate in the euro zone as well through quantitative easing to stimulate the economy, thus Bank of Canada’s move seems in sync with the ECB. However, if the U.S. economy continues to recover and grow as seen recently, we should expect an increase in their interest rates sooner or later, and our interest rate will have to adjust accordingly. Unless the Bank of Canada is willing to prop the Canadian dollar by selling U.S. dollars, which they cannot do indefinitely.

So, in order to know what will happen to the Canadian interest rates, we need to keep an eye on the U.S. economy. And in the meantime, enjoy the lower interest rates while they last.