Mark Carney announces his presence with authority

The Bank of Canada lowered its overnight rate target by 1/2 of a percentage point to 3 1/2 per cent:

[T]here are clear signs that the U.S. economy is likely to experience a deeper and more prolonged slowdown than had been projected in January. This stems from further weakening in the residential housing market, which is adversely affecting other sectors of the U.S. economy and contributing to further tightening in credit conditions. The deterioration in economic and financial conditions in the United States can be expected to have significant spillover effects on the global economy. These developments suggest that important downside risks to Canada's economic outlook that were identified in the MPRU are materializing and, in some respects, intensifying.

The Bank now judges that the balance of risks around its January projection for inflation has clearly shifted to the downside, and, as a result, the Bank is lowering the target for the overnight rate. Further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance and to achieve the 2 per cent inflation target over the medium term.

I was expecting and recommending a cut of 25 bps, but there was a decent case to be made for a reduction of 50 bps. Unfortunately, it was not the case that the Bank made.

The good case would have been based on two arguments:

• Core inflation is still way below its target.
• Credit conditions are tighter than what they were last summer. A 50 bps cut still means that effective borrowing rates are higher than they were when the Bank last had a tightening bias.

The case outlined in the interest rate announcement seems much weaker:

• Now that the current account has gone negative, the CAD is unlikely to appreciate much more in the near term. And if the CAD-USD rate stays stable while oil prices continue to rise, then exports will be somewhat cushioned from the US slowdown.
• Domestic demand has been taking up the slack from weak export growth for the last six years; it's hard to see why we should be panicking about the ability to shift output away from exports at this stage.

So while I'm not overly concerned about the Bank's decision, I am somewhat worried about the reasoning it used to arrive at it. Especially if this reasoning is used to guide future interest rate decisions.

Comments

[E. Poole]

Stephen,

80% of Canadian exports go to the US.

A slowing, likely negative growth US economy, is sufficient justification for dropping rates given anticipated lags of roughly one to two years for monetary policy shocks to affect the real economy.

I would be most pleasantly surprised if the US can survive US$100+/barrel oil and US$3.25+/gallon gasoline and not go into recession in the context of current home-grown financial crisis.

You wrote: Now that the current account has gone negative, the CAD is unlikely to appreciate much more in the near term. And if the CAD-USD rate stays stable while oil prices continue to rise, then exports will be somewhat cushioned from the US slowdown.

Yes, aggregate exports will be cushioned. But manufacturers and service exporters will get hammered.

The high degree of correlation between benchmark oil prices and the Canadian dollar valued in US dollar units is probably another good reason for the BoC to drop rates.

Monetary policy is a lousy way of trying to compensate for bad public resource management that Canadians universally love, but can you blame the BoC for trying?