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Bank of Canada cuts rates by 25 basis points

Tuesday, January 22, 2008

OTTAWA — The Bank of Canada has cut its key interest rate by a quarter of a percentage point, and is indicating there are further cuts to come, in order to help Canada deal with a brutal U.S. slowdown.

The central bank said it is lowering its target rate to 4 per cent – the second month in a row for looser monetary policy – and said it was slashing its growth forecasts for the United States and Canada, for this year.

Inflation in Canada is also proving to be less of a threat than the Bank of Canada expected in its last forecast in October, the bank said, suggesting that prices will remain suppressed until the end of 2009.

Still, the central bank resisted calls for a steeper rate cut of half a percentage point, saying the Canadian economy continues to operate in overdrive for now, despite the clouds on the horizon.

The U.S. Federal Reserve announced its surprise massive interest rate cut of three-quarters of a percentage point about an hour before the Bank of Canada officially issued its own announcement on Tuesday morning. By that time, however, the Canadian central bank had already handed over its statement to journalists in a lock-up – essentially leaving the Bank of Canada with little choice but to stick with its plan to cut by a quarter of a percentage point, regardless of the Fed's move. (A Canadian official said the Fed did not give the Canadian central bank any advance notice of its surprise cut.)

“Financial market conditions have deteriorated since October, leading to a tightening of credit conditions in industrial countries,” the Bank of Canada said in a one-page statement accompanying its rate announcement. “Given this, and a deeper, more prolonged decline in the U.S. residential housing sector, the 2008 outlook for the U.S. economy is now significantly weaker than at the time of the October [forecast].”

Canada's economy will be hit hard, the central bank said, especially in the export sector. But because commodity prices have risen in the past few months, Canadian businesses and consumers have seen their incomes grow, and domestic demand is expected to hold up relatively well.

All told, Canada's economy will slow this year, and begin gradually recovering in 2009, the bank said. But in order to get there, more rate cuts will likely be necessary.

“In line with this outlook, the bank has decided to lower the target for the overnight rate and further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance and to return inflation to target over the medium term,” the bank concluded.

The Bank of Canada will publish full details of its projections and analysis on Thursday.

It did not say on Tuesday by how much it would slash its growth forecasts for the United States and Canada, and merely indicated that the changes would be significant.

In October, the central bank projected that the Canadian economy would expand by 2.3 per cent in 2008, and 2.5 per cent in 2009. Now, the bank believes 2008 will be weaker than that, but 2009 will be stronger. Private-sector forecasters expect, on average, that the Canadian economy will grow by about 2.1 per cent, but they are in the midst of revising that number down, given the rapid deterioration in the United States.

The central bank's last official projection for inflation in Canada was that it would fall below its 2 per cent target this year but return to target by the second half of 2008. On Tuesday, however, the Bank of Canada extended this timeline by an entire year, saying inflation would not return to target until the end of 2009 – suggesting it sees weakness in the North American economy for some time to come.

As for the United States, the Bank of Canada's old growth expectations in October were for 2.1 per cent in 2008 and 3.0 per cent in 2009. Many private-sector analysts say the United States is skating close to a recession, while some believe the recession is already here.

With the Fed's 75-basis-point cut on Tuesday morning, there is now an appreciable gap between the American's key interest rate of 3.5 per cent and the Canadian key interest rate of 4.0 per cent. Talk of such gaps in the past has led to significant strengthening of the Canadian dollar – something Canadian exporters would no doubt have serious trouble dealing with right now.

© The Globe and Mail