Is there a prime rate cut in our future?

Feb 4, 2013

By David Larock

Recently the Bank of Canada (BoC) met and, as expected, left its target overnight rate unchanged. More surprisingly though, the bank also eliminated its oft-repeated warning about near-term rate increases. Here is the exact wording from the announcement:

“While some modest withdrawal of monetary policy stimulus will likely be required over time, consistent with achieving a two per cent inflation target, the more muted inflation outlook and the beginnings of a more constructive evolution of the imbalances in the housing sector suggest that the timing of any such withdrawal is less imminent than previously anticipated.”

The first notable wording change was the BoC’s “more muted inflation outlook”, which was supported by the December Consumer Price Index (CPI), released by Statistics Canada. The report showed overall inflation of only 0.80 per cent over the most recent 12 months, along with core inflation of 1.10 per cent over the same period. (Reminder: core inflation strips out the more volatile inputs to the CPI like food and energy prices.)

Our inflation rates have fallen steadily over the past year and a half and are among the lowest in the world. If they remain at current levels, the BoC will have to think seriously about lowering its overnight rate, not raising it, to achieve a two-per-cent inflation target over the medium term.

Sound crazy? Let’s look at the other key wording change in the BoC’s latest statement – the “more constructive evolution of the imbalances in the housing sector”.

Our borrowing has slowed sharply of late and household credit is now expanding at a rate of only three per cent, the lowest level seen since 1999. If household credit growth, which BoC Governor Mark Carney has repeatedly called the “greatest threat to our domestic economy”, continues to stabilize, the BoC’s interest-rate policy should align more closely with the actual economic data going forward.

I say this because I have long maintained that the bank’s repeated warnings to Canadians about imminent rate increases have not actually been supported by economic data, domestic or otherwise, for some time. In fact, many analysts have long speculated that the BoC was using its higher-rate warning as a kind of moral suasion to persuade Canadians to slow their borrowing (a tactic that I would argue had little meaningful impact).

Even if you look at the BoC’s own economic forecasts, which were just updated in the latest Monetary Policy Report (MPR), there is plenty to suggest that the next move in the overnight rate could just as easily be down as up:

* The BoC cut its forecast for Canadian GDP growth from 2.40 per cent to two per cent in 2013. (Note: the bank upgraded our GDP growth forecast for 2014 from 2.40 per cent to 2.70 per cent but didn’t support this optimistic revision with a detailed explanation. And it doesn’t jibe with any of the bank’s projections for other countries in 2014, as you will see below). The bank now also expects our output gap (the gap between our actual output and our maximum potential output) to disappear in the second half of 2014, instead of by the end of 2013, as forecasted in the October MPR.

* The BoC cut its forecast for U.S. GDP growth from 2.30 per cent to 2.10 per cent in 2013 and from 3.20 per cent to 3.10 per cent in 2014. The bank now estimates that “fiscal consolidation will exert a significant drag on U.S. economic growth … (and this) will subtract roughly 1.5 percentage points from growth in both 2013 and 2014.”

* The BoC cut its euro-zone GDP growth forecast from 0.40 per cent to -0.30 per cent in 2013 and from one per cent to 0.80 per cent in 2014. The bank now believes that “the economic recovery will be slower than originally thought, in part because fiscal austerity measures and tight credit conditions are taking a greater-than-expected toll on economic activity”.

* The BoC takes note of China’s recent economic rebound but also points out that “other economic activity has slowed further in other major emerging economies.”
* On an overall basis, the report states that while “global tail risks have diminished (meaning the risk of a systemic shock to the global financial system that could be caused by an event like a sovereign debt default), the global outlook is slightly weaker than projected in October”. In other words, the global economic momentum arrow is pointing down across the board.

Variable-rate discounts are available in the prime minus 0.40-per-cent range (which works out to 2.60 per cent using today’s prime rate). While five-year variable rates only offer a small saving over their equivalent five-year fixed rates, the BoC announcements provided further reassurance that this saving should remain in place for the foreseeable future.

The bottom line: I have long argued that the BoC’s warnings about near-term higher rates would not come to fruition and the bank’s latest revisions to its interest-rate guidance confirm this view. With that question now put to rest I don’t think it’s crazy to wonder whether the next move in the overnight rate, when it eventually does come, has as much chance being a decrease as an increase. (And that’s especially true if the BoC’s latest international GDP growth forecasts are on the money.)

David Larock MBA, AMP, PFPC, CSC is a Toronto-based independent mortgage planner and long-time industry insider who specializes in helping clients purchase, refinance or renew their mortgages. He is an active blogger on mortgage related topics and his posts have been distributed in national media and by Realtors and financial planners.


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