Bank of Canada to Cut Policy Rate by a Further 50 Basis Points

Daily Forex Fundamentals | Written by RBC Financial Group | Oct 18 08 08:16 GMT |

The combination of a deteriorating outlook for the US economy, falling commodity prices and persistent financial market volatility are boosting the downside risks to Canada's economic outlook and will likely see the Bank of Canada lower the policy rate by 50 basis points at next week's meeting. Despite a concerted effort by global central banks and governments to ease market concerns about counterparty risk and shore up investor confidence, financial markets continue to flail with equity markets unable to sustain gains. Wholesale funding costs have started to ease but remain elevated meaning that the cost of capital for businesses and households is staying high and availability limited. A rate cut next week would follow up on the 50 basis points ease announced by the Bank on October 8 when the Bank joined several other central banks in a coordinated policy move. The Bank of Canada highlighted the significant tightening in credit conditions, weakening demand for Canadian exports and more moderate growth in domestic demand in the October 8 press release and said that "this action will provide timely and significant support to the Canadian economy." Given the steady decline in commodity prices since October 8, inability of equity markets to sustain an improved tone and increasingly weak US data reports, we think it is likely that the Bank will choose to act aggressively next week and cut the policy rate to 2%. Additionally, Friday's reports showing that business lending conditions tightened further in September according to both senior loan officers and Canadian businesses will give the Bank incentive to supplement its already-stimulative monetary policy stance. Should the Bank decide to hold the policy rate steady or cut by a smaller 25 basis point increment next week, we would look for a cut at the December meeting meaning that the overnight rate would still end 2008 at 2%. Our assessment remains that growth in Canada will be stronger than the US in 2009 although the pace will be slower than the economy's potential. The support for the domestic economy coming from the terms of trade will lessen going forward on lower commodity prices and the recession in the US will trim demand for Canadian exports. Our view that the significant tightening in credit conditions will begin to ease in the months ahead will go some distance to shoring up consumer and business confidence and prevent the economy from slipping into a recession. However the risk that spreads remain wide and lending standards tight cannot be discounted and supports the case for the Bank to move aggressively in the near term and then hold the policy rate at 2% for several quarters. Our forecast that the economy will return to a firmer growth path in the second half of 2009 suggests that the Bank will be in a position to make a small step toward removing some of this stimulus in the final quarter of next year and raise the overnight rate to 2.25%. RBC Financial Group http://www.rbc.com The statements and statistics contained herein have been prepared by the Economics Department of RBC Financial Group based on information from sources considered to be reliable. We make no representation or warranty, express or implied, as to its accuracy or completeness. This report is for the information of investors and business persons and does not constitute an offer to sell or a solicitation to buy securities.