Bank of Canada Holds at 3% Yet Again

For a third consecutive announcement, the central bank’s communications department reused the headline, “Bank of Canada keeps overnight rate target at 3 per cent.” This repetition implies that central bankers have not perceived a fundamental shift in the balance of factors considered since they last changed interest rates four and a half months ago.

In fact, much has changed in just the seven weeks since the Bank of Canada’s last interest-rate announcement (July 15). The need for economic stimulus has become more pressing and the capacity of monetary policy to control inflation has diminished. Therefore, the central bank should have decisively cut interest rates today.

Worsening Economy

The most recent Labour Force Survey release (August 8 ) revealed that Canada’s private sector eliminated 95,000 jobs in July. This employment news is the worst reported since the recession of the early 1990s. Last week’s Gross Domestic Product figures revealed that the Canadian economy is smaller now than it was at the end of last year. In the second quarter of this year, our economy grew at a pitiful annualized pace of 0.3% whereas the US economy grew at an annualized pace of 3.3%.

Many factors could help explain why Canada is now underperforming the US, but one may be that the Bank of Canada has provided less than half as much economic stimulus as the American Federal Reserve. Over the past year, the Fed cut target interest rates by 3.25% (from 5.25% to 2.00%). By the comparison, the Bank of Canada lowered target interest rates by only 1.50% (from 4.50% to 3.00%).

Although the Canada-US exchange rate has eased somewhat in recent months, the fact that interest rates are a full percentage point higher in Canada is still helping to hold the loonie significantly higher than warranted by purchasing power parity or other measures.

Changing Inflation

The last Consumer Price Index release (August 21) provided little justification for maintaining interest rates in an effort to control inflation. Many commentators had argued that the Bank needs to raise or maintain interest rates to quell inflation in western Canada, despite the pressing need for economic stimulus in central and eastern Canada. For many months, inflation had exceeded 2% only in Alberta and Saskatchewan.

The August 21 figures show inflation much more evenly spread across the country. From June to July 2008, consumer prices actually fell in Alberta and Saskatchewan, bringing annual inflation in these provinces into line with the national average. The changing regional distribution of inflation reflects changing causes of inflation.

When Canadian inflation was concentrated in Alberta and Saskatchewan, it could reasonably be attributed to economic booms in these provinces. Economists generally believe that central banks can limit this type of “demand-pull” inflation through higher interest rates.

Now that inflation is evenly spread across Canada, it cannot be attributed to a regional economic boom. Instead, consumer prices were higher everywhere because global commodity prices were higher. Economists generally agree that central banks cannot control this type of “cost-push” inflation. Certainly, Bank of Canada interest rates have no meaningful effect on the prices of gasoline, food and other global commodities.

In any case, these prices are now trending downward. The Bank of Canada’s last rate announcement (July 15) occurred just after oil had reached $147 per barrel. Today, oil is trading below $110 per barrel. Therefore, commodity-driven inflation seems likely to ease. Core inflation has remained at only 1.5% for four months. These developments should have prompted the Bank of Canada to cut interest rates to provide much-needed economic stimulus.

UPDATE (Sept. 4): Coverage by The Toronto Star, CanWest and Canadian Press

5 comments

  • Actually Erin I am a fan of fiscal stimulus and stable interest rates as the way to deal with a downturn. Monetary stimulus sets in motion speculative forces that do no good for goals such as equality, and solidarity with the excluded. Public spending and public investment are the best tools for public policy.

  • Hi Duncan,

    For those with Mortgages, or thinking about buying a house, car and other such things that drive the economy, I would think that lower interest rates are key linkage to prime the spending pump from worker’s pay packets not as caught up in the downturn. (at least not yet anyway, steel, public sector, mining, hi tech, etc).

    Fiscal is definitely a preferred but I would argue that this downturn does not make the whole pushing on a string concept as we have debated on this site as pronounced as some perceive it. Given the regional and the sector modality of the initial broadsides from this downturn, and the ongoing meltdown, monetary stimulus still can be effective within specific sectors. I would agree that it may not be as targeted as fiscal stimulus and does have the similar notions of equity and solidarity. I personally would not write it off. Lower the rates is my motto.

    But again potentially one must also look into the consumer credit stocks and flows and see what kind of impact and where on the monetary stimulus boundaries we are currently. Consumer credit from my last check are at all time highs and recently the government made changes to mortgage vehicles. (avoid the credit fiasco)

    Public spending and targeted industrial investment incentives would be the fiscal stimulus packages that we require.

    Looks like the Harper government is finally letting loose on the ford engine investment that the CAW membership has been after them for. It is so sad to see it take this long and be nothing more than a political carrot. That is down right dirty pool and I hope people see it for exactly what it is. The commitment was needed quite some time ago. I guess we will have about a month and a half of fiscal stimulus coming down the pipe.

    Sad really, one could hypothesize that the tories have been waiting until this election call to do any spending. For the sake of those faced with job loss and displacement I hope the tory coffers are a lot deeper than the one engine plant. Forestry right across the country could use some stimulus in terms of investment and worker displacement help.

  • If I had to choose between fiscal stimulus and monetary stimulus, I would definitely pick fiscal stimulus. However, I do not believe the two to be mutually exclusive. (On the contrary, to the extent that lower interest rates reduce public debt charges, they give governments more latitude to provide fiscal stimulus.)

  • I find three percent lots of stimulus, having bought a house and paid over 10 percent for the first mortgage. By the way for some reason I took a five year term in 1978, thus missing the 20 plus rates of 1981.
    Three percent is one percent in real terms.
    The spread between the Central Bank overnight rate and commercial rates is cause for concern. Even more serious is the inability of the central banks to address global payments imbalances.
    David Dodge was asleep at the switch as Governor, I have no idea if the new guy will be any better. if he leaves ratew where they are for the next few years, he would be way ahead of Dodge who never knew what he was doing as Governor.

  • The spread is a big problem, in fact like I have said here before, I wonder why they call the BOC overnight rate trend setting. I can’t imagine my mortgage being in the 1980’s. I imagine the critical voice’s had plenty of fuel back then. It is no wonder 1981-82 recession was so pronounced.

    Comparatively 3% is not quite the gathering storm that we sometimes make it out to be.But again, as you mention the spread is what we do have to have concern about. I do not have the data for this, but it seems that since the onset of the credit crisis, the banks have let that spread widen even more.

    I guess I am speaking more to the ability of the bank to influence the trend and to personify an interventionist stance.

    However your point is well taken and the lesson is learned.

    P.s. Can you imagine anyone taking a mortgage at those rates in ’81. I would really like to pull up a chart on that one. Was there a house sold in 1981? Legalized usury. Perhaps, one day we will all say that about credit card companies, pay day loan companies and the rest that currently charge those rates.

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