January 21, 2015 / 10:20 PM / 4 years ago

Bank of Canada shocks market with rate cut, blames oil plunge

OTTAWA (Reuters) - The Bank of Canada stunned markets by cutting interest rates on Wednesday, citing a threat to economic growth and its inflation targets from the dramatic drop in oil prices and said the bank stood ready to ease policy further if necessary.

Governor Stephen Poloz said the central bank’s surprise move to stimulate the economy provides “insurance” against risks for Canada, a major oil producer, stemming from the “oil price shock”. He said oil’s plunge could worsen household debt burdens by driving up unemployment and cutting incomes.

“We must remember that the world changes fast and if it changes again, we have the ability to take out more insurance or on the reverse, to reduce how much insurance we’ve taken out,” Poloz told reporters.

The bank cut its overnight benchmark to 0.75 percent from 1 percent, where it had been since September 2010, ending the longest period of unchanged rates in Canada since 1950.

The cut caught markets by surprise and sent the Canadian dollar to a nearly six-year low against the greenback CAD=D4. The Toronto stock market’s main index surged 1.8 percent. [CAD/]

Thirty-five economists polled by Reuters last week had unanimously forecast the bank would hold its rate at 1 percent on Wednesday, with most anticipating a rate increase in the fourth quarter of this year.

“We didn’t think things had deteriorated enough for the Bank of Canada to move as quickly as this,” said Adam Cole, head of G10 FX strategy at RBC in London.

Poloz pointed out the bank had been talking publicly about the economic costs of cheaper oil. “All the ingredients for the rate decision were out in the open. And I thought people were pretty close to it,” he said.

Swap markets, which had priced in only a small possibility of a rate cut on Wednesday, are now pricing a strong possibility of a further easing this year. BOCWATCH

Oil prices have fallen by half in the past six months to below $50 a barrel, and Canada is the biggest foreign supplier of crude oil to the U.S. market. While cheaper energy will broadly help the United States and other importers, it will be “unambiguously negative” for Canada, the bank said.

The bank slashed its economic growth estimate for the first half of 2015 to 1.5 percent from 2.4 percent, meaning excess capacity in the economy will increase rather than being mopped up.

It estimated cheaper oil will shave 0.75 percentage point off what Canada’s growth would have been during the year, after weighing mitigating factors.

The bank said, however, that growth should pick up to 2.4 percent next year from 2.1 percent for full-year 2015.

Poloz said that before taking into account the rate cut, the bank had projected it would take until late 2017 for the economy to use up excess capacity. That is at least another year later than the bank had forecast in October, a delay it found unacceptable.

Poloz said he balanced the need to cut rates with concerns the move could encourage people to take on more debt, reigniting Canada’s housing boom and increasing already high household indebtedness.

“While it is true that a lower profile for interest rates may exacerbate household imbalances at the margin by encouraging more borrowing, the far more important effect will be to mitigate those imbalances by cushioning the decline in income and employment caused by lower oil prices,” he said.

“A soft landing in the housing sector continues to be the most likely scenario,” the bank said, adding, however, that a sudden market correction in housing could have a big negative impact on the economy and inflation.

Cheap oil will have a dramatic effect on overall inflation, which the bank said would be below its target range of 1 to 3 percent for most of 2015 and as low as 0.3 percent in the second quarter.

“Clearly the bank is more worried about the economy and missing its inflation target than it is about household financial imbalances and the overvaluation in some housing markets,” said Sal Guatieri, senior economist at BMO Capital Marketsin Toronto.

The bank’s latest forecast was based on $60 oil, well above current prices around $48. If prices are just 10 percent below $60, that is, $54, this would lower inflation by another 0.3 points, it said.

“Prices are currently lower but our belief is that prices over the medium term are likely to be higher (than $60 a barrel),” it said.

The bank acknowledged oil prices below forecast could turn inflation briefly negative, but Poloz made clear he did not consider that to be deflation in the full sense of the term since it would not reflect a broad price fall.

Additional reporting by Toronto bureau; Editing by Peter Galloway and Jeffrey Hodgson

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