The Bank of Canada ended its longest period of inaction since the 1950s with a rate cut it calls "insurance" against the potentially destructive effects of the collapse in oil prices.
Calling the oil-price shock "unambiguously negative" for the Canadian economy, Bank of Canada Governor Stephen Poloz said a cut to 0.75 per cent from 1 per cent in its key lending rate was necessary to stave off emerging risks such as weak inflation and a real-estate downturn. Already, the drop in oil prices has led to layoffs in the oil patch, postponed energy projects and signs of a housing bust in Alberta.
The rate cut, the first by a Group of Seven country in the face of oil prices that have tumbled to about $46 (U.S.) a barrel from $110 last June, caught financial markets off guard. The Canadian dollar plummeted about 1.5 cents to close at 81.07 cents, and the TSX climbed 251.98 points to 14,560.42. Lower rates mean holding cash in Canada is now relatively less attractive.
It is not clear yet if Canada's big banks will lower their rates. Historically, Canada's largest lenders have followed suit when the central bank cut its key interest rate. However, Toronto-Dominion Bank said Wednesday that it now weighs many factors before cutting its prime rate, sending the message that it would like to keep the status quo in order to sustain healthy loan margins. Officially, the remaining Big Six banks declined to comment, but some privately expressed a similar sentiment as TD.
Mr. Poloz, in his second year as Governor of the Bank of Canada, said he acted now to make sure the rate cuts get to work fast, adding that he'll cut again if crude prices fall further. "The world changes fast and if it changes again, we have room to take out more insurance," he said, speaking to reporters.
Economist David Madani of Capital Economics said that "clearly, [the BoC] is far more worried about a severe housing market correction."
Other economists speculated that the central bank's primary motive is to speed the transition from an economy driven by oil exports to one supported by manufactured goods, such as cars and machinery.
Canada's two-speed economy is undergoing a major reversal of fortunes, with the once-booming energy sector fading while the manufacturing sector is rebounding, Mr. Poloz said.
"It's really like there are two economies," he said. "One economy is actually growing pretty well and is showing great promise and the other one is taking a break."
But Mr. Poloz rejected suggestions that he's actively trying to drive the dollar lower to boost non-energy exports. "Market consequences will be what they are," he said.
The central bank warned that lower oil prices would take a sizable bite out of economic growth in 2015, delay a return to full capacity and hurt business investment – a trend that has already triggered layoffs and spending cuts in Alberta's oil-and-gas industry.
But the effects could spread further, threatening financial stability as a result of possible losses to jobs and incomes, as well as driving inflation lower, the central bank said.
The risk for households cuts both ways. Lower oil prices hurt the Canadian economy through oil-patch layoffs and cancelled investments. They also make the entire country poorer because Canada will generate less wealth from the oil it sells to the world.
But lower interest rates could encourage already heavily indebted Canadians to borrow even more, further inflating home prices in cities such as Toronto and Vancouver.
The bank's new forecast assumes a price of "around" $60 a barrel for Brent crude, more than $10 above where it is now. But the central bank said prices are likely to be higher than $60 over the next two years.
Its decision coincided with the release of a new and more pessimistic economic forecast. Following the lead of most private-sector forecasters, the central bank slashed its Canadian growth forecast to 2.1 per cent this year, from 2.4 per cent, before a rebound to 2.4 per cent in 2016. The worst effects of the oil collapse will be felt in the first half of this year, when the central bank expects annualized growth of 1.5 per cent, nearly a full percentage point lower than its October forecast.
The Canadian economy grew at an estimated rate of 2.4 per cent in 2014.
Crude's effects on the economy will be broad and profound, the bank warned. Investment in the oil-and-gas sector will decline by as much as 30 per cent this year, while lower returns on energy exports will eat into Canadian incomes, wealth and household spending.
The bank also hinted at a possible spread to other parts of the country of a real estate slump already under way in Alberta. "The extent to which the downturn already evident in Alberta will spill over into other regions remains to be seen," the bank pointed out in its monetary policy report.
The bank also expressed growing angst about the impact that oil could have on inflation. Consumer price increases are already "starting to reflect the fall in oil prices," the bank said. It said overall inflation will fall well below its 2-per-cent target, averaging just 0.6 per cent in 2015. Core inflation, which strips out volatile food and energy prices, is expected to average 1.9 per cent this year.