Posted on January 20, 2016

Bank Of Canada Does Not Cut Rates

Bank of Canada Does Not Cut RatesIn an evenly divided call by market analysts, the Bank of Canada maintained its target for the overnight rate at 1/2 percent. The Bank said that inflation prospects are largely as expected and that “the dynamics of the global economy are broadly as anticipated in the Bank’s October Monetary Policy Report (MPR).”

Really?  Oil prices have plummeted to unexpected lows. Stock markets are declining sharply and the Canadian dollar has fallen more than expected and certainly, the output gap will remain wider for longer than suggested in the October MPR.

The Bank called the setback for the Canadian economy from the further decline is oil prices temporary. The Bank now expects the economy’s return to above-potential growth to be delayed until the second quarter of 2016. The Bank projects Canada’s economy will grow by about 1-1/2 percent in 2016 and 2-1/2 per cent in 2017, with the output gap closing around the end of 2017. This is the Bank’s forecast without including the positive impact of fiscal measures expected in the next federal budget.

Really? I feel like the economic forecasters at the Bank of Canada are living in a parallel universe–where things are a lot rosier than here on planet earth.

Don’t get me wrong, there are a lot of good reasons for the Bank of Canada to have refrained from cutting rates.  The Canadian dollar has already fallen sharply and a rate cut could have imprudently triggered a currency rout. With so much concern about household debt, another rate cut would run the risk of encouraging excessive borrowing. As well, with interest rates already so low, another cut is likely to have very little macroeconomic benefit and the Bank should keep some powder dry in case things deteriorate further in coming months. Moreover, the feds are going to goose the economy with infrastructure spending, so taking a wait-and-see attitude makes sense.

But to suggest that the current weakness is due to temporary factors and a rebound is in train without the fiscal stimulus lacks credibility and appears sanguine at best and irresponsible at worst. Oil prices are not falling due to temporary factors. The world is adjusting to an alternate reality where oil supply is well in excess of sustainable demand and more supply is coming on stream from Iran. Canadian oil is among the most expensive in the world to produce and prices received by Canadian oil producers (Western Canada Select (WCS) in the chart below) are well below prices elsewhere. This inevitably continues the painful restructuring in the oil patch. These are not temporary factors.

Norway–another oil giant with expensive production–recognizes its need to accelerate its economic transformation. In its October 2015 budget, the Norwegian government declared that “the economic outlook is different than we have been accustomed to over the past 10-15 years…Oil is no longer the growth engine of the economy.”  Faced with the need to restructure, the government is keen to shift Norway from its dependence on oil towards other industries. Norges Bank, the central bank of Norway, has given forward guidance that interest rates may be cut further in 2016 from record lows despite worries of a house price bubble in Oslo and elsewhere due to increasingly low rates. Norges Bank has warned that house price inflation was higher than expected and that household debt–already at record highs–would continue to outpace income growth.

The Bank of Canada has been behind the curve ever since the decline in oil prices began in 2014, revising down its forecast for the Canadian economy in each quarterly Monetary Policy Report. How long can unanticipated temporary factors be blamed?

Oil prices and Bank of Canada easing