BOC Policy Monitor – Bank of Canada shocks markets with rate cut‏

January 22, 2015

The Bank of Canada surprised markets by cutting the overnight rate by 25 basis points to 0.75%. The BoC supported that decision by highlighting downside risks to growth brought by the slumping oil prices. The central said that:”The oil price shock increases both downside risks to the inflation profile and financial stability risks.”  The BoC didn’t change its forecast for global growth this year (3.4%) as upgrades to the U.S, Eurozone and China were offset by downgrades to Japan and the rest of the world. The central bank bumped its U.S. growth forecast to 3.2% for 2015 (from 2.9%).


With regards to Canada, the central bank downgraded its forecasts for both growth and inflation. Real GDP growth is now expected to be just 2.1% this year (versus 2.4% in its last forecast) and that is based on an assumed $60 average for oil. The downgrade was entirely due to investment whose contribution was lowered from +0.4 to -0.1%, i.e. now a drag on the economy in 2015. Interestingly, consumption was left unrevised despite the stimulus from lower pump prices. Looking at the quarterly growth profile, the BoC lowered most quarters this year, with the first half averaging just 1.5% annualized. The projections for potential GDP were unchanged at 1.9% for 2015. The central bank estimates the output gap was in the range 0.7-0.9% at the end of Q4. Because of the much weaker growth profile, the BoC now sees the output gap only closing “around the end of 2016”, i.e. a bit later than what it had expected last October. The BoC is concerned about the lower terms of trade and expects that to affect income. That’s reflected in the forecast for real gross domestic income growth which was chopped from 1.7% to just 0.6% this year.


Reversing the trend of last year when it had to consistently raise its inflation forecasts, the central bank this time lowered its inflation forecasts in light of slumping oil prices. Both core and headline inflation are not expected to return to 2% before late 2016. More importantly, the central bank says that “there is an exceptional amount of uncertainty about the profile for total CPI”.


In his press conference, Governor Poloz pointed out that today`s move was an insurance policy that the Bank is taking. He saw Canada as a two speed economy, one part is slowing down (energy sector) while the other one will gather momentum (manufacturing and exports). He thought that it is the weakening part that will be felt first. So today`s action was taken to ease the transition. He also mentioned that the BoC model suggested that if no action was taken, the output gap could have taken a year longer than previously expected to close. If the model would have suggested a delay of only a quarter then the decision would have been different. As far as household imbalances are concerned, the Bank recognizes that lower rates will result in more borrowing but at the same time it will support job creation and income. The net effect will be that the debt-to-income ratio at the national level will be lower than if nothing had been done. Given the uncertainty regarding oil prices, a risk management approach justifies the rate cut. The situation will be evaluated again in a couple of months and monetary policy will be adjusted as needed.


Bottom line:

The Bank of Canada shocked markets by cutting interest rates. The downside risks to inflation and financial stability brought by the oil price collapse have moved to the forefront of the BoC’s concerns, and the central bank felt it had no other choice than provide some stimulus to the economy. For the past three years, the central bank’s concerns about forecast uncertainty were most external in nature. This time around, forecast uncertainty is centered on the domestic economy because the central bank is concerned about the ability of Canada to withstand the headwinds brought by slumping energy prices. Are further rate cuts in the pipeline? That’s possible if energy prices do not rise as expected the central bank. Note that the BoC warned that “there is an exceptional amount of uncertainty about the profile for total CPI”. That said, the central bank may wait to see the effects of the combined stimulus impact coming from interest rate reduction and a much depreciated Canadian dollar (the BoC just chopped three cents from CAD with this morning’s announcement).

Read the attached file for the full BoC Policy Monitor


Paul-André Pinsonnault/Krishen Rangasamy


The attached report along with selected research from the Economics and Strategy Group can also be accessed by clicking the link below:

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