April 21, 2009 / 1:31 PM / in 8 years

Bank of Canada surprises markets with rate cut

<p>The Bank of Canada building is pictured in Ottawa March 3, 2009.Chris Wattie</p>

OTTAWA (Reuters) - The Bank of Canada surprised markets by cutting its benchmark interest rate to a historic low of 0.25 percent on Tuesday from 0.5 percent, saying it was prepared to keep it there for another full year in an aggressive bid to spur a slumping economy.

In an unusual move, the central bank told markets directly to expect rates to stay at the current level until the end of the second quarter of 2010, assuming inflation remains tame.

It also cut its economic growth forecasts to reflect its view that the Canadian recession will be deeper -- and recovery more gradual -- than it had previously predicted.

Nonetheless, it suggested that the cumulative rate cuts it has made since December 2007 may be sufficient to help turn the economy around, and that it may not have to print money to buy securities in the market, a policy known as quantitative easing.

It will, however, set out a framework on Thursday for that kind of unconventional policy.

"It is the bank's judgment that this cumulative easing, together with the conditional commitment (to keep rates steady), is the appropriate policy stance to move the economy back to full production capacity and to achieve the 2 percent inflation target," the central bank said in a statement.

The rate cut took markets by surprise and triggered an immediate fall in the Canadian dollar against the U.S. dollar to a three-week low of C$1.2507, or 79.96 U.S. cents. The currency later recovered to finish at C$1.2363 to the U.S. dollar, or 80.89 U.S. cents, up from Monday's close of C$1.2385, or 80.74 U.S. cents.

Canadian treasury bill yields also fell.

A majority of primary securities dealers had expected the bank to hold rates steady.

"Committing to keeping (rates) there for the next year is quite a startling revelation," said Aron Gampel, deputy chief economist at Bank of Nova Scotia.

"It reflects the concern the central bank may have for the global economy. More importantly I think that they are trying to engineer confidence in Canadian households and businesses that interest rates are going to stay low for the foreseeable future," he said.

Ten out of 12 primary securities dealers surveyed by Reuters last week had said they expected the central bank to use some form of quantitative or credit easing within the next three months, but the Bank of Canada did not signal on Tuesday that it would do so.

"The primary focus is going to be on whether they enact any form of quantitative easing because they haven't committed to actually doing anything," said George Davis, chief technical strategist at RBC Capital Markets.

The bank outlined a series of technical adjustments it will make to reinforce the new overnight rate and avoid disorder in money markets.

These included narrowing its operating band to 25 basis points from 50 basis points and making the overnight rate the lower limit of that band as well as significantly increasing the balance in the settlement system.

The bank downgraded its forecasts for economic growth and now sees recovery starting in the fourth quarter of this year and not the third quarter, as it predicted in January.

It expects the Canadian economy to contract 3 percent this year, compared with its projection in January of a 1.2 percent decline. It backed down from its rosy outlook for 2010, which sparked widespread criticism, lowering its growth estimate to 2.5 percent from 3.8 percent.

Even Finance Minister Jim Flaherty conceded later on Tuesday that the bank had been "overly optimistic" in its January projections. But he said the revised outlook did not mean additional fiscal stimulus was needed.

"It reflects a little more of a pessimistic outlook in terms of economic performance," Davis said.

The central bank sees total and core inflation staying lower longer, returning to the bank's 2 percent target only in the third quarter of 2011 instead of mid-2011.

Additional reporting by Randall Palmer, Frank Pingue, Jennifer Kwan, Ka Yan Ng and David Ljunggren; editing by Peter Galloway, Jeffrey Hodgson and Rob Wilson

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