Canada 'entering a recession,' central bank slashes key rate to 1.5 per cent

OTTAWA — The Bank of Canada took an axe to short-term interest costs Tuesday, cutting its key rate by three quarters of a point in a move to get consumers and businesses borrowing and spending again and help revive the slumping economy.

The drop in the central bank rate to the lowest level in half a century at 1.5 per cent is aimed at loosening up the pursetrings of households and businesses. But it it will take a while for the rate cuts to wind through the national economy, which is shrinking and now is in recession.

In the meantime, many economists say, the federal government must deliver a major stimulus package of billions of dollars in infrastructure spending, targeted help to struggling industries and other confidence-enhancing moves to free up frozen credit markets and put more money into people's pockets.

Prime Minister Stephen Harper said Tuesday's central bank rate cut will provide "significant economic stimulus." But he conceded more must be done in the Jan. 27 federal budget.

Economist Mike McCracken agreed, saying Ottawa has "to put some money out" to help the economy recover.

"There's an old addage that you can go so far with monetary policy but you cannot push on a string." said McCracken of Ottawa-based Informetrica Ltd. "You need some effective demand on the other side (to make people) want to borrow, to seek out investment funds and (for) consumption. That's what missing at the moment.

"A healthy fiscal stimulus goes right along with this rate cut. It would be like a gin and tonic rather than just the tonic that we got from the bank today."

Tuesday's cut means the Bank of Canada has reduced interest rates by about three percentage points since last year - half of that since early October - to cope with rising unemployment and thousands of job losses.

The central bank said dramatic action was needed given the rapidly deteriorating global economy and the impact of the financial crisis and plummeting commodity prices, factors that have hit Canada's resources-based economy hard.

"The outlook for the world economy has deteriorated significantly and the global recession will be broader and deeper than previously anticipated," the central bank said in a statement accompanying the rate cut.

"While Canada's economy evolved largely as expected during the summer and early autumn, it is now entering a recession. The recent declines in terms of trade, real income growth, and confidence are prompting more cautious behaviour by households and businesses."

The lower interest rates, when passed on by the commercial banks, will make it cheaper for businesses and households to borrow for expansion and consumption. Such spending boosts economic growth and provides jobs to stimulate the recessionary economy.

Given the lag time needed to get major infrastructure projects started, Scotia Capital economist Derek Holt said it was essential for the Bank of Canada to show leadership by cutting rates because Ottawa's stimulus - when it comes - may not impact the economy for another year.

However, rate cuts alone won't get the economy moving again. While falling borrowing costs are helpful, the tough operating environment at many businesses means they still won't borrow money to expand until they see a spurt in orders from their customers in the battered U.S. economy or corporate confidence improves.

The same thing applies to ordinary Canadians, hit by rising debt, unemployment fears and consumer confidence at its lowest level in more than a quarter century.

Another factor that lessens the impact of Tuesday's bank rate cut is the fact the commercial banks have not passed on the full three-quarters of a point bank rate cut to their customers because of tighter credit markets in which they operate.

Some critics accuse the banks of profiteering and Liberal MP and party consumer critic Dan McTeague says the central bank should be able to force lenders to match the central bank cut.

But in today's difficult global credit crunch, the bond and other financial markets where chartered banks borrow remain volatile and don't automatically respond to central bank rate signals as they did in the past.

On Tuesday, all the big banks cut their prime lending rate by only half a point to 3.5 per cent. The prime sets the bar for many business and consumer loans, including open mortgages, but in recent months, the day-to-day credit market has pushed borrowing costs higher for consumer and car loans and many mortgages not linked to prime.

In early October, the chartered banks balked at passing through fully the Bank of Canada's rate reduction but later made up the difference when Ottawa agreed to buy $25 billion in mortgage assets off their books and free up the money to expand credit in the economy.

The central bank's dramatic chop to the overnight rate Tuesday was the largest since October 2001 in the aftermath of the 9-11 terrorist attacks.

A recession is commonly defined as two consecutive quarters of economic shrinkage and by that measure Canada has avoided a recession this year since there was growth in the third quarter.

However, given a sudden drop in economic activity that began in October and prospects of continued slowdown throughout early 2009, many economists have said Canada's recession has begun in earnest.

Although most private-sector analysts had predicted a half-point cut from the central bank, Holt praised the central bank for rising to the needs of the economy.

Given the "dovish" tone of the bank statement, Holt said Canadians should expect another half-point cut at the next scheduled rate decision date on Jan. 20. He said it is possible the overnight rate - the rate banks charge each other on one-day loans - will fall below one per cent by late winter.

"Beforehand, they were criticized for not being aggressive enough but now they have come around," Holt said.

Tuesday's statement was the first in which the Bank of Canada was unequivocal that the country had fallen into a recession. The closest that governor Mark Carney had come previously was last month when he said recession was a distinct possibility.

Since then the vast majority of economic indicators have been in retreat, including retail sales, auto purchases, housing starts and prices, commodity prices - and dramatically - last month's 70,600 shrinkage in jobs.

The central bank's move was partly a "catch-up" after it did not cut rates more deeply in October, and was urgently needed because of the lack of economy-boosting spending by the Conservative federal government, commented IHS Global Insight economist Dale Orr.

"Today the cry for fiscal stimulus for Canada is loud and clear," Orr wrote.

Although monetary and fiscal stimulus differ in the manner they boost growth, Orr said interest rates cuts are preferred by economists because their impact is quicker and can more readily be reversed when the economy recovers.

The central bank will not publish new projections for the economy until Jan. 22, just days before the next federal budget.

In its new outlook, IHS projects the Canadian economy will shrink 0.4 per cent in 2009 and won't recover fully until late 2010.

The Bank of Canada did not predict how long the slump will last but said bold actions by governments and central banks, especially in the United States and Europe, are beginning to loosen up money markets and support world economic growth.

It said other factors are helping Canada counter the economic slowdown, including the depreciating loonie which is making exports more competitive.

After the rate reduction, the currency fell by more than a cent to below 78 cents US. but gained back some of the loss, ending the day at 79.08 cents US, down nearly two thirds of a cent.