Central bank warns U.S. turmoil a risk

September 6, 2008

bus7.gifSays interest rate already low enough to stimulate economy


September 4, 2008

OTTAWA — The Bank of Canada held its key interest rate steady, saying rates are already low enough to stimulate a stagnant economy that remains vulnerable to economic and financial turmoil in the United States.

The central bank’s decision yesterday to keep its overnight rate at 3 per cent maintains its benchmark rate a full percentage point higher than the U.S. Federal Reserve Board’s key rate. But compared with other countries, and once inflation has been taken into account, that rate is considered quite stimulative, spurring consumers to spend instead of save.

While the sluggish rate of growth, weakening global demand and abating inflation that characterize Canada’s economy these days would often have set the stage for rate cuts in times past, the Bank of Canada issued a gentle reminder that it has already cut its key interest rate by 150 basis points since last fall. (A basis point is 1/100th of a percentage point.)

“The bank judges that the current level of the target for the overnight rate remains appropriately accommodative,” the bank said in a one-page statement that was non-committal about what it would do in future interest rate decisions.

Canada’s central bank is holding steady while the central bank in Australia – whose economy and currency are also driven by commodity prices – is slashing its key interest rate. But it’s important to look at what the Bank of Canada has already done, said economist Paul Ashworth with London-based Capital Economics.

In Canada, real interest rates – which factor out the rate of inflation (now well above 3 per cent) – are close to zero, he said, while in Australia, real interest rates are about 4 per cent.

In Canada, “policy is already at an accommodative level,” Mr. Ashworth said in an interview. “They’ve already set themselves up for a period of weak growth.”

The Bank of Canada acknowledged that the domestic economy has slowed, but only “modestly” and added it “remains strong” because the credit crunch that continues to roil borrowing in the United States and other countries is not nearly as severe in Canada.

Inflationary pressure has abated since the oil-fuelled scare of a couple of months ago, the bank said, but commodity prices are so volatile of late the central bank did not seem prepared to assume they wouldn’t boil over again soon.

“Global inflationary pressures remain elevated, with potential implications for import prices and the dynamics of inflation in Canada,” the bank said.

The bank doesn’t want to count on the Canadian dollar for help, either. The recent slide in the loonie will help spur global demand for Canadian products, but it comes at a time when global demand is softening, it pointed out.

“The weaker global growth and the decline in the Canadian dollar will have opposing effects on the demand for Canadian goods and services.”

The source of Canada’s economic weakness right now lies outside its borders, in the form of a collapsing housing market and financial turmoil in the United States, and slower global growth, said Paul-André Pinsonnault, senior fixed-income strategist with National Bank Financial. So the central bank is right in not attempting to combat such weakness with interest rate cuts, he said.

Still, monetary policy is not as stimulative these days as the central bank’s interest rate would suggest, both in Canada and the U.S., pointed out David Wolf, chief economist at Merrill Lynch Canada. That’s because the borrowing costs faced by households and businesses have not come down as much as the central banks’ rates, owing to the credit crunch.

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