• 25 basis point cut brings interest rate policy to
its effective lower bound at a 0.25% overnight
target, and Bank commits to this overnight rate
until end of Q2/2010.
• As Bank seeks to keep inflation expectations
anchored, future monetary stimulus will rest on
market interventions and direct injections with
this framework to be unveiled on Thursday.
The Bank of Canada cut 25 basis points, bringing the
overnight target to 0.25%. With unprecedented openness,
the Bank committed to this interest rate until Q2/2010 in
order to anchor longer term interest rates. Having cumulatively
eased 425 basis points since December 2007, interest
rate policy is at its effective lower bound (a 0% rate
would create technical problems – particularly in money
markets), and further monetary stimulus will require market
interventions and direct injections. The Bank provided
immediate measures by extending the duration of its Purchase
and Resale Agreements (PRA) and increasing available
settlement balances in the Large Value Transfer System
(LVTS) to $3 billion. However, the announcement of
its framework for Quantitative and Credit Easing (QE/
CE) will come in Thursday’s Monetary Policy Report
(MPR).
Given the deteriorating economic conditions and
disinflationary pressures, the cut was in-line with our expectations.
As was widely expected, the Bank clarified
its economic outlook, observing the intensifying and synchronized
global headwinds and revising its forecast for
rebound in 2010 downwards from 3.8% to 2.5%. The Bank
also forecasts a deeper 3.0% contraction in 2009 – a revision
from its January forecast for a 1.2% contraction –
and anticipates that recovery won’t take hold until Q4/
2009. Although also revising potential growth downwards,
the Bank’s revised forecasts mean a longer and wider
output gap, which will levy a protracted downdraft on in- Grant Bishop, Economist 416-982-8063
flation. To this end, the Bank was very open about its
own inflations expectations, anticipating headline CPI inflation
to trough at -0.8% in Q3/2009 and crawl back to
the 2% target by 2011. In line with its price stability mandate,
the Bank must now anchor inflation expectations
against the downside.
With terrific transparency, the Bank has made an unprecedented
but appropriate commitment to the maintenance
of the overnight target until Q2/2010. This certainly
buttresses its credibility in counter-acting disinflation.
The overnight target most directly acts through traditional
lending institutions, but influences pricing in open markets
– particularly money markets. However, bank credit continues
to flow and the main clog remains in open-market
financing, as shown by still wide spreads on medium-term
debt. The Bank must act to influence longer term rates.
The main event is now the QE/CE framework to be
unveiled in Thursday’s MPR. QE involves direct injections
into the money supply while CE would target particular
clogged markets. The Fed has so far proceeded
by purchases of treasuries and certain asset-backed instruments.
However, the Bank of England has created
precedent for direct purchases of corporate bonds. Although
corporate bonds have rallied in past weeks, spreads
remain elevated. For Canada, QE/CE does not appear
imminent but nonetheless appears likely.
Lastly, while the rate cut will adversely affect bank
margins and money markets, the Bank has also narrowed
the operating band, lengthened PRA terms, and increased
the LVTS settlement balances. The Bank will pay 0.25%
on banks’ reserves, instead of 0% under the previous
framework. By increasing banks’ access to overnight borrowing,
the enlargened LVTS could theoretically expandthe money supply by nearly 4%.
