Arthur Donner on Interest Rates

From Today’s (December 3) Toronto Star

Canada’s economy is on the cusp of some very tough times, and it will require enlightened and timely central bank action to ensure that our economy avoids a recession next year.

The crux of Canada’s economic problems is related to the slowing U.S. economy which threatens to fall into a recession, the huge increase in the loonie relative to the U.S. dollar, which has been devastating Canada’s manufacturing industries, and the credit and liquidity problems affecting our own financial institutions.

The U.S. Federal Reserve, America’s central bank, has sharply downgraded its projections for the U.S. economy next year. Fed policy-makers project the U.S. economy to grow between 1.6 per cent and 2.6 per cent in 2008, substantially lower than a forecast they issued in June. The Fed policy-makers also indicated that there are higher-than-usual risks that the U.S. economy will perform worse than they forecast.

In other words, Fed officials are essentially warning that they wouldn’t be surprised to see a U.S. recession in 2008. Financial markets have actually been ahead of the Fed concerning the possibility of a 2008 recession.

The high Canadian dollar has also made matters worse for Canada’s economy. Ever since the Canadian dollar bottomed out at 61.79 cents (U.S.) on Jan. 21, 2002, the loonie has been driven up by the perception that the U.S. dollar was overvalued, by surging commodity prices, and by Canada’s robust trade surplus. The Canadian dollar recently peaked at $1.10 (U.S.), which represented about a 75 per cent increase in value from its all-time low.

The latest recession talk and a slight softening of oil prices has moved the loonie down a bit to just below parity with the U.S. dollar. Consequently, the trough-to-peak revaluation moderates to about 61 per cent against the U.S. dollar.

No matter how you calculate it, however, the sharp increase in the value of the Canadian dollar has triggered the loss of about 250,000 high-wage manufacturing jobs since 2002. And job losses seem to be accelerating this year.

Finally, what originated in early August as a problem with U.S. subprime mortgages has spread to a major liquidity squeeze on the banking systems in the U.S., Canada and Europe. Unfortunately, there is little evidence that the international credit market freeze is nearing an end.

Regulators, central banks and investors are still uncertain about the full extent of the credit-induced losses. Canada’s own version of the liquidity squeeze may not be as bad as in the U.S., but nonetheless the Bank of Canada was forced to inject liquidity on numerous occasions into the Canadian banks in order to maintain orderly markets.

Canada’s own version of the problem, the $35 billion of frozen asset-backed commercial paper, has not yet been solved. Indeed, this is not too surprising, as it is difficult to determine a price for exotic instruments that do not trade actively.

Easier monetary policy (either by open market operations or the lowering of benchmark interest rates) is an important lever for getting the banks to lend and the public to borrow, but monetary policy will not easily or automatically resolve the current solvency crisis.

Here is how our central banks and the timing of prospective interest rate changes fit into the current picture.

The next U.S. central bank interest rate-setting meeting date is Dec. 11, and the markets widely expect a 25 basis point interest rate cut at that time.

The Bank of Canada’s next rate-setting date is today. Canada’s benchmark rate, the overnight rate, is currently 4.5 per cent, identical to the 4.5 per cent federal funds policy rate.

If the Bank of Canada does nothing today, and the Fed cuts interest rates a further 25 or 50 basis points, this will surely boost the value of the loonie against the U.S. dollar.

With crude oil priced at $100 (U.S.) per barrel in sight, the loonie could remain above parity for quite some time.

This economist is suggesting that the Bank of Canada should try to get ahead of the curve and cut rates significantly today.

A major rate cut would no doubt lower the value of the Canadian dollar against the U.S. dollar, and perhaps encourage a further downward drift in the value of the loonie into a range where Canada’s industries could be more competitive.

Arthur Donner is a Toronto-based economic consultant.

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