Canada cuts rate

The Bank of Canada slashed its key short-term interest rate about as low as it can go Tuesday and said it may have to resort to extraordinary measures to stimulate the economy which, it acknowledged for the first time, is unlikely to recover this year.

The central bank did what most private-sector economists advised it to do, cut the trend-setting overnight rate to an all-time low of 0.5 per cent and Canada's commercial banks quickly followed, cutting their prime rate by half a percentage point.

The lower prime rate, which falls to 2.50 per cent on Wednesday, will benefit some mortgage holders but will have little or no immediate impact on many corporate borrowers or credit card holders and will further reduce some interest rates paid to savers.

Scotiabank chief executive Rick Waugh said at his bank's annual meeting in Halifax that the lower interest rates is "a step forward" for the economy but insisted that the No. 1 priority is to "stabilize the world financial system"

"There's a huge amount of incentives that the governments are putting in. But unless we get our financial sector stabilized, then all these incentives will not work as well," Waugh said.

Bank of Canada governor Mark Carney said earlier that even with the central bank's overnight rate at unheard-of lows, the stimulus provided by traditional monetary policy is likely not enough help for the economy.

And Carney said the bank now sees recovery coming later than it had last projected, possibly in early 2010 instead of the third quarter of this year.

"Given the low level of the target for the overnight rate, the bank is refining the approach it would take to provide additional monetary stimulus, if required, through credit and quantitative easing," Carney wrote in a statement.

From the outset, the central bank's January economic outlook had been described by many observers as overly optimistic but Carney has said since then that the outlook acknowledged both the potential upside and downside.

A lot depended on how the situation unfolded in the global financial system, Carney said at the previous rate setting on Jan. 20, coincidentally the same day Barack Obama officially became president of the United States.

Obama and his administration has been quick to push for several massive stimulus efforts, aimed at propping up the financial sector, the automotive sector and some hard-hit American consumers, such as homeowners who are unable to afford their mortgages.

While the Canadian economy as a whole has been shrinking dramatically, as a result of lower U.S. and world demand for oil, gas, minerals and manufacturing goods, the Canadian banking system continues to be solid and the five biggest banks remain profitable.

The Bank of Canada didn't give specific examples on Tuesday on what type what specific measures are available to provide monetary stimulus to the Canadian economy, which shrank by 3.4 per cent in the October-December quarter.

BMO deputy chief economist Doug Porter said the central bank is considering a process whereby it injects money into the financial system by buying up assets such as government bonds, asset-backed commercial paper and even corporate bonds directly.

"Simply put, the bank is preparing to pull out all the stops to support the economy," Porter said.

Canada's major banks appeared ready to play ball with Carney: shortly after the announcement, Royal Bank (TSX:RY), Bank of Montreal (TSX:BMO), TD Bank (TSX:TD), CIBC (TSX:CM) and Scotiabank (TSX:BNS) announced that they would cut their prime rates by half a percentage point, in step with the central bank.

But while variable mortgage rates tied to prime are being reduced, longer-term and fixed rates have not kept pace with the central bank's moves, partly because chartered banks are reluctant to lend into a recession for fear of failures and partly because their own borrowing costs are higher than would be expected.

Still, Jim Rawson, a regional manager Toronto-based mortgage firm Invis, says the most recent cut in combination with measures in the government's January budget will increase borrowing.

"A lot of people will be interested in re-financing mortgages and it will spur a lot of first-time buyers," Rawson predicted.

The federal budget, yet to make its way through Parliament, offers $750 in tax relief for first-time home buyers while increasing the limit that can be withdrawn from RRSPs for a down payment by $5,000.

"Quite honestly, people are saying nobody is buying, but there seems to be a lot activity right now. In my region, applications doubled in January from December," Rawson said.

By most measures, Canada's credit markets are in better shape than in most industrialized countries, although still far from normal.

Carney has noted that while Canada's chartered banks continue to lend, many other financial institutions have tightened their practices or shut down altogether, reducing the availability of credit as a whole.

His reference to non-traditional monetary measures confirms that the central banker knows he has exhausted interest rate cuts as a means of stimulating lending and borrowing in the economy.

Darcy Briggs of Bissell Investment Management in Calgary said the bank could trim rates to 0.25 per cent - and likely will, as the U.S. Federal Reserve has done - but "practically, what would that do?"

There are technical reasons why a zero interest rate is impractical, economists say.

The other surprise in Tuesday's statement was that Carney appeared to back off his relatively rosy forecast for the Canadian economy, which envisioned growth returning in the third quarter of this year and rebounding to 3.8 per cent next year.

"The outlook for the global economy has continued to deteriorate since the bank's January... update, with weaker-than-expected activity in major economies," Carney said Tuesday.

"National accounts data for the fourth quarter of 2008 and other indicators of aggregate demand point to a sharper decline in Canadian economic activity and a larger output gap through the first half of 2009 than projected in January."

Carney said potential delays in stabilizing the global financial system, along with low consumer confidence and larger hit on household wealth, "could mean that the output gap will not begin to close until early 2010."

Tuesday's statement does not officially alter the forecast, but strongly implies that both this year's 1.2 per cent contraction will be worse and that the recession may last until next year.

"Reading between the lines, it's a safe assumption that their (January) forecast has already gone out the window," said Porter.

Most economic indicators have come in far weaker since January's much-criticized bank outlook, including Monday's report that the Canadian economy has shrunk by 3.4 per cent in the last quarter of 2008, far worse than the bank's negative 2.3 per cent projections.

As well, Canada lost 129,000 jobs in January, a massive amount, which Carney did not know when he made his forecast.

But possibly the most critical factor is that the global economy, especially among industrialized nations, appears to be in free-fall.

The fourth quarter saw GDP fall by 6.2 per cent in the United States, six per cent in the United Kingdom, 5.7 per cent in the Eurozone, 10.3 per cent in Mexico and a massive 12.7 per cent in Japan.

And far from stabilizing, the U.S. financial system is lurching from crisis to crisis. On Monday, the U.S. government said it was adding another $30 billion to the bail-out package for the giant insurance company American International Group Inc. after it reported a staggering US$61.7-billion in quarterly losses.

"Stabilization of the global financial system remains a precondition for the global and Canadian economic recoveries," Carney noted in his statement.