The Bank of Canada cut interest rates for the first time in almost five months Tuesday, citing the combined impact of a soaring loonie and weaker-than-expected demand on this country's recovering economy, and economists say the door remains wide open for more moves if the picture doesn't brighten.
The move lowers the central bank's key target for the overnight rate to 2.5 per cent, from 2.75 per cent.
That rate is the bank's main monetary policy tool. It tells the country's major financial institutions the average interest rate the bank wants them to charge when they lend each other money for one day or overnight.
The market had been primed for another rate cut — the first since September — although economists were fairly evenly split on whether the bank would move.
Almost immediately after the decision, Canada's big banks followed suit. Royal Bank of Canada led the way, cutting its prime lending rate to 4.25 per cent effective Wednesday, followed by Canadian Imperial Bank of Commerce, Bank of Nova Scotia, Toronto-Dominion Bank, Bank of Montreal and Laurentian Bank.
In its accompanying statement, the central bank cited a below-target inflation, the loonie's upward trajectory against the U.S. dollar and weaker-than-expected domestic demand as factors in its decision.
"Despite stronger global economic growth, the rapid appreciation of the Canadian dollar against the U.S. currency has cut into the overall growth of aggregate demand for Canadian goods and services through weaker exports and increased imports," the central bank said.
The loonie gained more than 20 per cent against the U.S. dollar last year and has continued to climb early in 2004.
Despite the rate cut, the dollar continued to hold its ground in early going, suggesting that the markets had anticipated the latest move and priced in cut. By 1p.m., the dollar — which had fallen somewhat in the lead up to Tuesday's announcement — was on the rise again, tacking on nearly a full cent in the hours after the decision was announced.
The loonie closed trading up 0.67 cents to 77.48 cents (U.S.).
The latest rate cut reduces the spread between the Bank of Canada's target for the overnight rate and the comparable U.S. Federal Reserves target for the federal funds rate to 150 basis points. (A basis point is 1/100th of a percentage point.)
The spread between rates in the two countries has widely been credited with supporting the loonie during its flight over the past year.
But several analysts suggested Tuesday that a single rate cut won't be enough to cool the loonie.
"The bank will need to pull the trigger again in March to offset the ongoing drag from the loonie's strength," TD Bank senior economist Marc Lévesque noted in a report.
Also factoring into Tuesday's decision, the bank said, are recent signs that fourth-quarter economic growth may not be as strong as originally expected.
"Although employment growth has continued to be vigorous, recent indicators of domestic demand in the fourth quarter of 2003 have been somewhat weaker than projected," the bank said.
"As a consequence, the output gap at the end of 2003 appears to be somewhat larger than the bank was expecting."
Some analysts suggested as well that the wording of the bank's statement — coupled with its prediction that inflation will likely remain below the centre of the central bank's target rate until late 2005 — suggest rates could fall again when the next fixed-date policy announcement is delivered later this winter.
"The bank strongly signalled to markets that it feels Canada is in a prolonged period of low rates," Royal Bank assistant chief economist Derek Holt said.
"...Overall, a meagre quarter-point rate cut alone won't lift the clouds, but this morning's cut coupled with indications of an easing bias at least acknowledges a number of critical areas of uncertainty that have crept into the outlook in recent weeks."
The bank's next decision is due March 2.
Economists had been fairly evenly split on whether the bank should move rates Tuesday, with a slim majority calling for a quarter point rate cut.
Those favouring a further reduction in borrowing costs had cited the negative impact of a higher dollar on the nation's manufacturing and export sectors.
They also pointed to the probability that fourth-quarter economic growth in this country will likely come up short of the central bank's own previous target of about 4 per cent at an annual rate.
The bank had indicated in the past that it wouldn't hesitate to lower interest rates if the rising loonie got in the way of Canada's economic rebound.
Last year, the bank raised rates twice early on to head off soaring inflation but later reversed course and cut twice as the country battled back from a string of unforeseen economic shocks.
Rates in this country have been on hold since Sept. 3.
Those arguing against a rate cut Tuesday had said the strong recovery now playing itself out in the United States should offer sufficient stimulus for this country without the need to lower rates further.
The Bank of Canada will elaborate on its outlook for the Canadian economy on Thursday when it releases its monetary policy report update.
