On Wednesday, the normally cautious Bank of Canada did something that shocked the world, or at least the economists, traders and investors who closely monitor the central bank.
The drowsy institution, which had held its benchmark overnight rate at 1% since late 2010, the longest such pause in its history, announced that it would be cutting the rate by a quarter point, to 0.75%.
The bank characterized this latest move as insurance against the risks of falling inflation and possible financial instability. And that suggests this isn't the beginning of a new easing cycle, so much as a temporary measure to bolster the country's economy until growth reaccelerates.
Longtime readers will recall that back in the heady days of 2012, the Bank of Canada (BoC) was one of the first central banks in the developed world to take a hawkish stance toward monetary policy as the country's economy appeared to have shaken off the lingering effects of the Global Financial Crisis.
But Canada doesn't operate in a vacuum. Exports account for about 30% of the country's gross domestic product (GDP), and each year roughly three-quarters of those exports are absorbed by the U.S.
As the nascent U.S. recovery continued to drag on at levels that were downright anemic, at least until recently, while Canada's own economy decelerated, the bank was forced to abandon its upward bias.
However, the BoC was caught in a delicate balancing act between trying to prime Canada's economy, while not helping further inflate the country's housing bubble.
The fear was that a rate cut could spur further borrowing by the country's debt-burdened consumers--Statistics Canada recently reported that the ratio of household debt to disposable income hit a record high of 162.6% during the third quarter--while a rate increase could choke off emerging growth in other areas of the economy.
But crude oil's collapse finally altered the calculus. In its latest policy announcement, the BoC observed that the sharp drop in oil prices "will be negative for growth and underlying inflation in Canada."
Prior to crude's swoon, the central bank had forecast GDP would grow by an average of 2.4% in 2015 and 2.3% in 2016. But with the price of North American benchmark West Texas Intermediate crude oil having plunged nearly 57% from its trailing-year high, the BoC now sees growth coming in at 2.1% this year.
The bank forecasts markedly weak growth for the first half of the year, with GDP rising by an average of just 1.5%, before reaccelerating in the second half, particularly during the fourth quarter.
Among the bank's concerns is a serious drop in business investment in the energy sector, which we've already seen as a number of exploration and production companies have announced dramatic cuts to their capital budgets, while weaker terms of trade "will have an adverse impact on incomes and wealth, reducing domestic demand growth."
Although the resource space accounted for 8.1% of GDP in 2013, according to Statistics Canada, the sector is estimated to have been responsible for as much as 35% of private non-residential investment.
The BoC says falling energy sector investment will pare growth by a tenth of a percentage point, in contrast to prior forecasts that it would add four-tenths of a point to GDP this year. According to the Canadian Association of Petroleum Producers, energy sector spending is expected to decline by 33% this year, to CAD46 billion.
So energy's contribution to GDP doesn't fully reflect how the money it generates and borrows flows through the country's economy.
The good news is that the bank is more optimistic about the medium term, as evidenced by its projections for the second half of the year, though it acknowledges that its rosier outlook for that period is clouded by considerable uncertainty.
"Outside the energy sector, we are beginning to see the anticipated sequence of increased foreign demand, stronger exports, improved business confidence and investment, and employment growth," the central bank observed. Those are the top items on the BoC's wish list as it awaits the economy's eventual transition away from its dependence on overextended consumers.
But while there are indeed signs that this long-anticipated rotation has begun, the question is how quickly it will take to be fully realized.
Lower interest rates will certainly be helpful in aiding this transition. Meanwhile, a rapidly rebounding U.S. economy--the consensus forecast is for U.S. GDP to grow by a relatively robust 3.2% this year--should also provide a boost.
A lower exchange rate should help kick-start Canada's export economy as it makes the country's goods more attractive to consumers in other countries, especially the U.S.
The Canadian dollar has fallen sharply since mid-2014, as a result of two key factors.
First, the U.S. Federal Reserve became more hawkish about its own monetary policy by concluding its extraordinary stimulus with an eye toward its first short-term rate hike since late 2006. Then, of course, crude's sudden collapse further undercut the currency.
And with the BoC's latest move providing additional confirmation that the two central banks are heading in opposite directions in terms of monetary policy, the loonie will likely head even lower.
In fact, the exchange rate dropped by 2 cents following the BoC's announcement, which is a sizable swing in the world of currency trading. The loonie currently trades near USD0.806, its lowest level since the Great Recession.
Finally, lower prices at the gas pump will help give both U.S. and Canadian consumers additional purchasing power.
In contrast to the BoC's conservative projection, private-sector economists are more sanguine about the economy's prospects. According to Bloomberg, the consensus forecast among institutional economists is for Canada's GDP to grow by 2.4% this year, just shy of full capacity.
This article originally appeared in the Maple Leaf Memo column. Never miss an issue. Sign up to receive Maple Leaf Memo by email.
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