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Bank of Canada finally acts 
15 July 2015

In a highly anticipated decision, the Bank of Canada lowered the overnight rate by 25 basis points today, to 0.50%. That is the second rate cut this year, after the Bank surprised markets back in January with its first 25-basis point cut. The Bank of Canada cited a considerably lower outlook for Canadian growth which has increased the downside risks to inflation.

The Bank of Canada outlined its latest economic forecast in its accompanying Monetary Policy Report (MPR). The Bank described global growth as having faltered in early 2015, due to weakness in America and China. Specifically, as China's economy rebalances to a more sustainable growth path, prices of certain commodities important for Canada's exports have been pulled down. The Bank of Canada continues to expect global growth to strengthen, particularly the American economy, in the second half of 2015 and through 2016-17.

However, Canadian economic growth, or lack thereof, has significantly under performed the Bank's expectations. The Bank of Canada now expects that the Canadian economy contracted in the first half of the year and will grow by only 1.1% this year. The Bank of Canada also downgraded its 2016 real GDP growth forecast to 2.3% (from 2.5% in April's MPR), however it expects growth to pick up further to 2.6% in 2017. The Bank of Canada cited further downgrades to investment spending plans in the energy sector, as well as weaker-than-expected non-energy exports. As a result of this growth downgrade, the Bank now expects the economy to return to full capacity in the first half of 2017; roughly half a year later than previously expected.

While core inflation has recently been running above the Bank of Canada's target, it downgraded this outlook further out in the forecast horizon. The Bank does not project a lasting return to 2.0% on core inflation until Q2 2017. The Bank of Canada also continues to emphasize underlying inflation, rather than its traditional ex-volatile items core measure. It sees underlying inflation as currently running around 1.5-1.7%, lower than previously communicated.

Finally, the Bank of Canada acknowledged the vulnerabilities associated with household imbalances remain significant and could edge higher, however Canada's economy is undergoing a significant and complex adjustment which requires additional monetary stimulus.

The Bank of Canada has penciled in a 0.5% contraction for Q2. These mark  two quarterly declines in GDP. Although they anticipate a rebound in Q3 and beyond, their forward looking language was quite dovish, emphasizing the downside risks to inflation and the "significant and complex adjustment" that Canada's economy is undergoing. This raises the risk that the Bank of Canada is looking to provide further monetary stimulus, depending on how the economy progresses.

Some observers have spoken out against the wisdom of another rate cut in Canada due to risk of exacerbating the already high level of household debt-to-income in the Canada. However, the Bank  of Canada has judged the "significant and complex adjustment"  which  Canada's economy is undergoing outweighs the risks from household imbalances.

An interest rate cut is not fully priced in by markets. Government of Canada bond yields have fallen since the announcement and the Canadian dollar has weakened to a new low of roughly 77 U.S. cents. A weaker Canadian dollar will lend a hand to Canada's export sector that has faltered thus far in 2015, which is increasingly being counted upon to drive growth going forward.





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