OTTAWA—In a surprising move on Wednesday, the Bank of Canada cut its overnight rate from 1 percent to 0.75 percent due to the sharp drop in oil prices and the effect it is having on growth and inflation. The policy rate had been held unchanged at 1 percent since September 2010 and most market participants were not expecting any change on this date.
Canada’s central bank released its latest quarterly monetary policy report (MPR) on the same day, Jan. 21, which extensively discusses the impact of lower oil prices on the Canadian economy. Updated projections for growth and inflation were also provided.
Oil prices were around US$80 a barrel at the time of the last MPR in October 2014; they are now below US$50 a barrel. This sharp fall in oil prices has been an adverse shock to the Canadian economy, and the expected slower growth in the first half of this year is a “material setback” to the Bank’s projected return to 2 percent inflation and full employment.
The Bank used a level of US$60 a barrel in its oil price assumptions, expecting prices will be higher than they currently are over the projection horizon going to the end of 2016. There is additional risk here in that oil is currently below US$60 a barrel and near-term supply dynamics for oil don’t look favourable.
“The considerably lower profile for oil prices will be unambiguously negative for the Canadian economy,” according to the MPR. Growth is now expected to average about 1.5 percent in the first half of 2015 as opposed to 2.5 percent as was forecasted in October. The Bank expects the economy to get back to full capacity near the end of 2016.
In his opening remarks at the press conference following the release of the MPR, Governor Stephen Poloz explained that, based on the oil price of US$60 a barrel, it would take the economy until late 2017 to use up its excess capacity (and reach full employment).
That risk of “accepting more downside risk on inflation was considered unreasonable,” said Poloz. The risk would be even greater if oil wound up averaging US$50 a barrel over the next two years.
The Bank’s inflation-targeting mandate necessitated a response, as total consumer price inflation (CPI) is expected to fall below the 1 percent lower bound for the inflation-control range during the first three quarters of 2015. Those projections are roughly a full 1 percent lower than what was projected last October.
While the Bank acknowledges the oil price drop acts as a tax cut for consumers and firms’ production costs, this positive effect is not expected to be as significant as in past experiences due to lingering uncertainty about the economy and consumers using gains in disposable income to pay down debt rather than raise spending.
The biggest impact of lower oil prices on the Canadian economy is expected to be the reduced investment in the oil and gas sector. The Bank conducted interviews with energy firms late last year and expects the level of investment to fall by 30 percent in 2015 and to remain roughly unchanged in 2016.
“Oil prices are now lower than current full-cycle break-even costs for many projects,” according to the MPR.
The Bank expects the economy to gradually strengthen in the second half of the year, with real GDP growth averaging 2.4 percent in 2016. The stronger U.S. economy, lower Canadian dollar, and monetary policy stimulus are the factors that the Bank expects will help the Canadian economy get there.
While oil dominated the Bank’s discussions, the MPR points out that the labour market is not as healthy as the 6.6 percent unemployment rate would suggest. The proportion of part-time workers continues to be elevated, and the Bank’s comprehensive measure of labour market performance hasn’t improved as much as the unemployment rate, since long-term unemployment remains close to the post-crisis peak and average hours worked remains low.
Financial Stability Risk Reduced With Rate Cut
The Bank’s press release no longer makes mention of the elevated household debt levels. In fact, household imbalances, Canada’s biggest risk to financial stability, are first mentioned on page 19 of the 26-page MPR.
The oil price drop is a financial stability risk for the housing sector if, due to an increase in unemployment (fall in disposable incomes), households are no longer able to service their already-elevated debt load. Therefore, the price drop has essentially increased the probability of an adverse shock to housing. Lower incomes due to oil prices ranging from US$50–US$70 a barrel could lead to an increase in the debt-to-disposable income ratio by about four percentage points.
The Bank’s analysis suggests that, due to the rate cut, the disposable income denominator in the debt-to-disposable income ratio will rise more than the debt numerator, thus lowering the overall ratio gradually and reducing financial stability risks.
“We believe the most reliable way to reduce financial stability risks is to do what we can to get the economy back to full capacity and sustainable inflation,” said Poloz.
The Bank is no longer providing any forward guidance in its statement and is reacting to the immediate problem of the magnitude of the shock in oil.
“All of the ingredients were out in the open,” for a rate cut said Poloz. “We concluded that the benefits of acting now rather than waiting would outweigh the costs of any short-term market volatility that might arise.”
Market reaction was sudden and sharp as the Canadian dollar fell by about 2 percent from roughly US$0.829 to US$0.81. The Canadian government bond yield curve also reacted in the short end with the two-year bond yield falling 0.30% and the five-year bond yield falling 0.20%.
The Bank of Canada’s next interest rate announcement date is March 4. The next MPR will be released on April 15.