On Wednesday, the Bank of Canada lowered its target for the overnight rate to 0.5%.
In the past few weeks, economists were split on whether the BoC would make this move despite the obvious weakness in both the domestic and global economies, says Darcy Briggs, portfolio manager with Franklin Bissett Investment Management.
Read: BoC cuts rate to 0.5%
Still, Briggs questions whether the rate cut was necessary. “One view is that rate-sensitive parts of the economy, such as housing, weren’t really in need of a rate cut. Financial conditions are already extremely loose. The cut was targeted toward exports, which are targeted toward the currency.”
And, he says, “Canada’s export problems aren’t a monetary problem; they’re a fiscal problem that needs to be solved by the federal government. If you look back 25 years, for example, there were all sorts of incentives given to the auto sector to entice [manufacturers] to come to Canada.”
Currently, “we don’t see a lot of that, and a lower currency will only go so far. Also, the consensus of the BoC is that the inflation [impact] of the currency will be transitory. But I don’t really agree with that because there’s the potential that inflation will remain higher than it needs to be.”
If that occurs, import prices could also rise. “So, your consumption dollar may not go as far,” says Briggs.
On the upside, bonds have reacted favourably to the news since bond markets tend to rally after rate cuts, says Briggs. But, “while loose monetary conditions are generally supportive of stock markets, too, the TSX is being more driven by global events right now. That’s because of its composition, which is heavily weighted in financials and commodities.”
Read: Dollar sinks, TSX rises after BoC rate cut
Overall, the rate cut may not buoy the Canadian economy, he notes, adding that confidence in the BoC may be lagging. “There have been a number of different swings [this year], from BoC being worried about housing in December, to a surprise rate cut in January. Then, they went from everything being [fine] in February, to an entirely different opinion in March.
“Following that, BoC had a bullish outlook in April. So, because of those differing communications, the confidence in the BoC has been hampered.”
An opposing view
Vincent Lépine, vice-president of global economic strategy at CIBC Asset Management, takes a different view. “Previously, we argued that any additional BoC easing would be conditional on deteriorating growth prospects, and this is precisely what happened today.
“The BoC is, rightfully so, concerned about slowing economic activity. Indeed, the Canadian economy not only has to cope with the negative impact of the sharp decline in oil prices, but also with slowing manufacturing and construction activity.”
Still, he agrees the central bank’s main intention was to surprise markets and lower the Canadian dollar. “If you look at the past couple of issues of the BoC’s [monetary policy] report, you can see it’s focused on non-oil exports.” They also touch on how well the U.S. economy is doing, and the strength of the Canadian dollar.
Read: Yellen says rate hike likely this year
The last point is most significant, he adds, because the loonie was too strong for too long. “In a normal environment, having one central bank [changing its views] and surprising markets and cutting rates close to 0% would be concerning. But this is happening across the developed world because there’s a global currency war going on.”
Before governor Stephen Poloz took the helm, explains Lépine, “the BoC remained neutral and didn’t fight that war. And the end result is we’ve been one of the ultimate losers because, over the last five years, the currency was too strong and killed manufacturing.”
All central banks have been playing the same game, he argues, including those in Australia, Sweden and Norway—in fact, those central banks have been more aggressive. So, “we understand what Poloz is doing and the BoC isn’t out of line. The central bank’s credibility isn’t in question, at least in this environment.”
Are more cuts on the way?
Briggs says the possibility of further rate cuts depends on both Canadian and global economic performance. “The export sector has to beat demand globally, and the U.S. hasn’t picked up as much as has been expected. But that could change.”
If U.S. growth picks up and if the Federal Reserve starts hiking rates, he adds, the BoC may again alter its strategy. “What happens with our largest trading partner does matter. Plus, a [Fed] hike in rates would be indicative of growth trends and would be positive for exports, and that would add to GDP growth in Canada. Then, the need for further rate cuts would be diminished.”
Plus, it generally takes six to nine months to feel the real effect of interest rate cuts, and there could be an uptick in growth by Q4 2015.
Currently, says Lépine, the BoC is projecting that real GDP growth between Q3 2015 and Q2 2016 will average 1.3%, down from 2.2%. “That’s slightly below our 12-month projection of 1.5%.”
Read: How to cope with low interest rates
But, given that the BoC does expect economic growth to recover modestly in the second half of this year, “today’s action may be the last until after the October election.”
Additional insights
Rob Spector, an institutional portfolio manager at MFS Investment Management, released the following insights on Bank of Canada’s rate cut:
- Today’s cut appears to be more reactive than proactive when contrasted with January’s rate cut.
- Easing should be successful if the goal was to weaken the Canadian dollar to help rebalance non-commodity export sectors that have slowed.
- The easing stands in direct contrast to Federal Reserve’s policy, based on testimony from chair Janet Yellen this morning. She still expects to raise interest rates this year.
- Every policy move takes us closer to the zero-bound level. So, while stimulating the economy is the goal, there’s a risk this easing could drive household debt and housing prices higher.
This story originally appeared on our sister site, Advisor.ca.