Bank of Canada cuts interest rate to lowest level practically possible

April 21, 2009

OTTAWA - The Bank of Canada has taken its key policy interest rate to the lowest practical level in an effort to combat what it says has become a deeper than expected economic slump.

The central bank sliced its target for the overnight rate in half to 0.25 per cent - "the effective lower bound" - and signalled it will keep it there until at least mid-2010 in an effort to arrest the economy's steep fall.

The commercial banks quickly cut their prime lending rate in step with the Bank of Canada's move. They were led by Bank of Montreal (TSX:BMO) which announced two minutes after the central bank's announcement that prime - the benchmark for variable-rate mortgages and other loans - was dropping by a quarter-point to 2.25 per cent. Some fixed mortgage rates were also trimmed.

Tuesday's Bank of Canada action suggests governor Mark Carney is willing to pull out all the stops to ease boost borrowing and lending, said economist Michael Gregory of BMO Capital Markets.

"I think this is a first step," he said. "Quantitative easing (expanding the money supply) is looming. I see printing money, high-powered money, as providing excess reserves in the banking system so the banks will do something with that extra money."

Carney will be outlining options for quantitative easing on Thursday, after embracing a new and darker outlook.

"The recession in Canada will be deeper than anticipated, with the economy projected to contract by 3.0 per cent in 2009," the bank's statement said.

It noted that "in an environment of continued high uncertainty," the global recession has intensified since the start of the year, and fiscal and monetary measures to stabilize the financial system "have taken longer than expected to enact."

As a result, Carney has basically thrown out the playbook he outlined in January.

Then, he predicted the recession would end by summer, with total economic shrinkage this year amounting to 1.2 per cent, and followed by a robust recovery in 2010.

Now the bank says the economy won't stop falling until at least the fourth quarter. This is in line with projections by the Organization for Economic Co-operation and Development and a growing number of private-sector economists.

It also is more reflective of an economy that has shed 270,000 since January.

Carney remains a relative optimist about the rebound, predicting a bounce-back of 2.5 per cent next year. While lower than his previous prediction of 3.8 per cent growth in 2010, it is still far above the OECD's forecast of 0.3 per cent.

"Given significant restructuring in a number of sectors, potential growth has been revised down," the bank's statement said.

"The recovery will be importantly supported by the bank's accommodative monetary stance."

Economists at the Bank of Nova Scotia termed the central bank's revised forecast a "significant mid-course correction ... and one that is on the mark across the board."

A Scotiabank note to clients said the central bank "has become much more realistically concerned about the longer-term outlook for the global economy and financial system including its reverberating influences upon Canada."

The new pessimism, or realism as some economists would call it, increases the odds that Carney will do more than outline options for quantitative easing on Thursday, and will soon move into uncharted territory.

The central bank sees no danger of inflation - in fact, it predicts prices will drop at a 0.8 per cent rate in the third quarter and not return to its two per cent target before the third quarter of 2011.

In addition to cutting its headline interest rate, the bank is extending the term of purchase and resale agreements it uses to inject liquidity into money markets, from one and three months to six and 12 months. Minimum and maximum bids will correspond to the historically low target rate.

BMO's Gregory noted that extending the term of PRAs up to a maximum of a year gives the commercial banks funding security at low cost for longer periods.

The central bank also said it will target a daily level of settlement balance in the financial system at $3 billion, a move it says will help drive the overnight rate to the bottom of the trading band.

Source: Julian Beltrame, THE CANADIAN PRESS

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