Some Musings on the Bank of Canada’s Latest Rate Cut

July 16, 2015
Jock Finlayson

What are we to make of the Bank of Canada’s decision this week to trim its benchmark policy interest rate by another 25 basis points, taking it to a near record low of 0.5%?

For one thing, the Bank is acknowledging that the energy-related downturn in capital spending and exports in Canada has been more pronounced than it was expecting earlier in the year – and the pain is likely to persist for a while yet. Canada’s economy, we are told, is facing “complex adjustments” that will unfold over the “next few years.” At the heart of these “adjustments” is a less rosy future for both crude oil and many other commodity prices. This is unwelcome news, as natural resource-based industries supply more than half of Canada’s exports and play a pivotal role in driving business investment in several regions of the country. A world of lower prices for oil and other commodities is a world in which Canadians can look forward to smaller increases in real incomes than we enjoyed during the decade that began in 2003 – a decade that coincided with a broadly-based global commodity upcycle that is now a fading memory.

Some other relevant context here is that Canada has become a more “energy-centric” economy since the 1990s. Energy products comprised fully one-quarter of our merchandise exports in 2013, compared to less than 10% in 1994. Within the overall energy space, oil dominates the export picture. The energy sector also looms large in non-residential investment, accounting for more than one-third of all private sector capital spending until very recently. The dramatic slide in world oil prices – and the realization that prices won’t be rallying strongly any time soon – has taken a toll on Canada’s economy. It is also weighing on overall business confidence, as executives and money managers come to understand that the country’s most important industry is in the midst of what is likely to be a multi-year contraction.

The central bank’s actions also speak to the reality that at a time of considerable macroeconomic weakness in Canada, it has fallen on monetary policy to shoulder the burden of supporting aggregate demand. Fiscal policy is essentially missing in action, as the federal government – despite its solid balance sheet -- focuses on staying out of deficit, and several provincial governments struggle to contain escalating debt/GDP ratios. Given Canada’s current economic circumstances and uninspiring growth prospects over the next couple of years, the existing monetary/fiscal policy mix is far from optimal, especially at the federal level.

Finally, this week’s cut in the central bank’s (already low) policy rate signals that the monetary policy tool box is running on fumes – at least in terms of “conventional” policy tools. To begin with, a 25 basis point reduction is too small to have any appreciable economic impact, other than to put more downward pressure on the currency. And with the policy rate now set at just 0.5%, the Bank of Canada will have little capacity to respond, in the event that the economy is hit by additional exogenous shocks or enters a period of protracted weakness. One can only hope that no nasty surprises lie ahead.

It is remarkable that, six years after the Canadian economy bottomed out at the tail end of the 2008-09 recession[1], the central bank’s benchmark interest rate sits perilously close to zero, with “real”, after-inflation market interest rates in negative territory across a significant swathe of the curve. Looking back, I can’t think of any Canadian forecasters who imagined, circa mid-2009, that interest rates and the “cost of money” would remain at such rock bottom levels a half decade or more into the future, particularly after several years of steady if not spectacular growth in both GDP and employment.

While the central bank is working with the tools at hand to deliver on a narrow mandate centred on managing inflation (and expectations thereof), one can’t help but worry about the troubles being stored up as a consequence of year after year of extraordinarily low interest rates and borrowing costs. Frothy housing markets and the accumulation of an unprecedented level of debt by Canadian households are the two most visible features of our present economic situation that have been aided and abetted by a long stretch of steroid-fueled monetary stimulus. More generally, it is worth asking whether sticking with a macroeconomic policy framework that has encouraged borrowing and leverage on an epic scale while punishing thrift and prudence may be doing subtle but real damage to the foundations of a productive economy. Too large a fraction of the scarce capital and entrepreneurial talent in Canada has been directed into relatively less productive sectors and activities (housing-related investment, financial engineering, and consumer spending), while too little has been deployed to build the products, technologies, skills, enterprises, and infrastructure that Canada needs to sustain a globally competitive 21st century economy. It is too early to render a firm judgement on how this will play out in the years to come. But policy-makers would be wise to pay more attention to the downside risks inherent in an increasingly unbalanced Canadian economy in which consumers, businesses and governments have become comfortable with the elixir of exceptionally cheap money.

[1] Output in Canada began to grow in the third quarter of 2009, after declining in late 2008 and over the first half of 2009.

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