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Turmoil in global credit markets is hindering the Bank of Canada's efforts to reduce borrowing costs for individuals and companies.
In its latest assessment of the economy, the central bank warned that even if it continues to lower its benchmark rate, rates lenders charge on mortgages and loans may rise.
Commercial lenders are paying more to get credit themselves in markets that remain reluctant to share money, the Bank of Canada said in its Monetary Policy Report.
Since the credit crisis kicked off last summer, banks have recovered only about three-quarters of their increased borrowing costs by charging higher rates to their customers.
That's not likely to last, Governor Mark Carney said.
"We do expect that to ultimately be passed on ... unless their funding costs come down sharply," Mr. Carney said at a press conference.
The report reinforced economists' expectations that the bank will continue to lower rates to offset the impact of a deteriorating U.S. economy.
The central bank's acknowledgment that it can only do so much to keep borrowing costs low signifies a change in a relationship that many borrowers have come to take for granted over the past decade.
Most people assume that when the central bank cuts, their own variable-rate mortgages or commercial loans will fall by the same amount.
That relationship is breaking down because commercial banks can't access credit at the low rates available before the collapse of the U.S. subprime mortgage market last summer.
Many financial institutions were backing their loans with securities linked to those mortgages.
Those assets are now essentially worthless, leaving the banks that held them with weaker balance sheets and riskier bets to pay the yield on any bonds they issue to raise capital.
So even though the Bank of Canada has slashed its benchmark rate by 1.5 percentage points since December, the risk premium lenders are demanding is keeping the spread between the central bank's overnight target and other loans wider than under normal conditions.
Earlier this week, Canada's chartered banks had contemplated holding their prime lending rates steady instead of following the central bank with its half-percentage-point rate cut.
Each cut to prime slashes their own profits, which are already being squeezed by the global financial turmoil, but the banks also realized they would face a major public backlash if they refused to pass along the central bank cuts.
After nine hours of sitting on the fence after the central bank cut on Tuesday, the commercial banks eventually matched the cut.
The banks' prime rate is what they charge their best customers. The banks use prime as a benchmark for many other rates. So far, the cuts to prime have moved in lockstep with the central bank, but some other rates, such as five-year mortgages, haven't.
"There seems to be a larger risk premium in the market," said Dustin Reid, a currency strategist at ABN Amro in Chicago and a former foreign exchange trader at the Bank of Canada. "I don't know what the event would be to swing the pendulum back to the other side."
Still, lending rates in Canada haven't been as susceptible to the global credit crunch as in the United States and Europe, where hedge funds have collapsed and central banks have had to bail out lenders to save them from bankruptcy.
The central bank characterized Canadian banks' losses as "limited," and noted that financial institutions, businesses and households all have healthier balance sheets than elsewhere in the world.
"Certainly it's much better to be in Canada during this situation than it is to be in other major economies," Mr. Carney said.
Mr. Carney, a former Goldman Sachs investment banker, acknowledged that the financial market turmoil has diluted the traditional power of monetary policy to influence the direction of the economy.
"It reduces, on the margin, the impact," Mr. Carney said. "But there are many more channels through which monetary policy does have an impact," he said, pointing specifically to how interest rates can influence the exchange rate or long-term borrowing rates.
In order to offset the diluted impact of monetary policy, the central bank has had to cut its key interest rate more than traditionally would have been the case, Mr. Carney suggested.
"We've tried to take that into account in calibrating monetary policy."
With files from reporter Tara Perkins in Toronto
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