Will (Should) the Bank of Canada Cut Its Main Rate Today?

It is so exciting to be an economist these days and it is even more exciting to be one in Canada right now. The country’s economy is going through turmoil because of the sharp decline in commodity prices that started around mid-2014, accelerated last year, and is very likely to continue throughout the current year.

Where oil goes, the Canadian dollar goes. At least, that has been the case for the last three decades or so. As a result, the dollar, commonly called the loonie, has lost 25% of its value in the past couple of years and it doesn’t seem to have found a floor yet, reaching 0.69 cents against the U.S. dollar this week – its lowest level in almost 13 years. In this context, today’s Interest rate announcement by Stephen Poloz, the Governor of the Bank of Canada (BoC), is a particularly important one; especially that Poloz himself made his first rate move exactly one year ago by lowering it from 1% to 0.75% which took markets by surprise at the time – he then opted for another cut to set the target rate at 0.5% in July 2015.

As the country's central bank rate decision looms, economists are divided over whether a possible cut in the already-low key rate is necessary to help stimulate the country’s economy. Will the BoC cut its reference rate? I don’t know and I believe that the question instead should be: Should it cut rates? And here, again, I don’t really have a clear answer. However, I will summarize the arguments on both sides of the spectrum to give you the pros and cons of such a decision.

The Bank of Canada Shouldn’t Cut

• Stimulus is coming. Therefore, there is no need to make the monetary policy more accommodative and deal with the consequences. It could be better to report the move and act, if needed, after the next federal budget. This will help the BoC make an enlightened decision based on the amount of fiscal support it will receive.
• It will undermine confidence in the Canadian dollar. The exchange rate serves as a barometer of the economy for many Canadians. Given the unprecedented pace of its decline, a further decrease in the value of the loonie might have the opposite effect, and hence hit growth, by shocking household confidence and eroding consumer sentiment while what the economy needs right now is more spending.
• Inflation. The increased prices of goods and services, those imported from the U.S. in particular, can gradually destroy Canadians’ standards of living by eating up their purchase power. It is true that there are many benefits to households mainly through lower energy prices, but the prices of imported goods are rising and the cost of travelling south of the border is suddenly becoming unaffordable to many.
• More debt. A lower interest rate means easier access to credit and, hence, more household debt. Although the relationship is not mechanical, it is wise to avoid any measure that could help build up debt among highly-indebted Canadian households. I should point out here that the average household had nearly $1.64 in debt for every dollar of disposable income; the highest among G7 countries.

The Bank of Canada Should Rather Cut

• Stimulus is coming. But it is not enough and/or will take time to take effect. Even if the new Liberal government’s stimulus plan is expected to provide sufficient support to put the Canadian economy back on the track of growth, the spending commitments, which also include a revamped child-benefits program and tax relief for the middle class, will not have a significant impact on the real economy before the end of 2017.  The struggle is now and immediate measures should be taken. If monetary policy is the only macroeconomic policy tool available, be it.
• Downside risks persist. A great deal of downside is expected anyway given Canada’s economic circumstances as it was shown by several revisions to Canada's real GDP figures by the BoC, the Parliamentary Budget Officer, and international institutions like the International Monetary Fund. Moreover, according to the International Energy Agency oil market may “drown in oversupply” in 2016 if production is not adjusted which is unlikely given that Iran, now relieved of sanctions, insists it will boost output. This no doubt means that pressure on prices will continue this year. That said, I expect the BoC to decrease its growth projections, one more time, in today’s Monetary Policy Report.
• We need a weaker loonie. A further decline in the value of the dollar will make Canadian goods and services more competitive abroad. A depreciated currency helps offset the effects of a beleaguered energy sector by making exports more attractively priced on international markets.
• It is no big deal. If the trend is to continue, we are talking about a cut of no more than 25 basis points. Is such a nudge down in interest rate a big deal? If you think the difference between 0.5% and 0.25% is a big deal, then yes. For the rest of us: not so much.

Exchange Rate and Terms of Trade

As I showed, there are several arguments for and against a cut in the Bank of Canada’s main rate. The danger from my point of view is to solely assume that a weaker dollar will automatically help us gain in competitiveness, boost exports, and revive our slowing economy. I want to point out to a problem that unfortunately not a lot of pundits are talking about: the dramatic deterioration in Canada’s terms of trade due to the slumping Canadian dollar. In the 12 months to November 2015, the terms of trade were 6.6% lower; reaching their lowest point of the Great Recession of 2008-09.

Meanwhile, the exports boom seems to take longer than expected. For the first eleven months of 2015 (the period for which the most recent data are available), Canada posted a trade deficit of $22.8 billion compared to a surplus of $5.8 billion over the same period in 2014. While this is due essentially to prices decline in the energy sector, the increase in exports of goods did not offset the 35-percent decrease in exported energy products. At the same time, imports increased by 4.6% over the same months.

Indeed, a weaker dollar helps Canadian exports, but one must bear in mind that the recent depreciation of the loonie was mainly against the U.S. dollar and, to a lesser extent, the Yen and Renminbi, while the exchange rate against the Euro followed a volatile path. However, as shown in the figure below, our national currency has registered an appreciation against the Peso in 2015 or, more accurately, the Mexican currency depreciated faster than its Canadian counterpart against the U.S. dollar.

But, why is this important? Well, Mexico has vis-à-vis the United States the same role Canada used to play during the 1990s. Mexicans are nowadays producing all kinds of goods for U.S. markets from shoes to automobiles. While the United States is still our largest trade partner and Canada is its 2nd largest supplier of goods imports, Mexico comes third and is de facto our main competitor. (Guess who the top supplier is?)

Ok. What can be done to fix the situation? As H. L. Mencken, Nietzsche's most influential American interpreter, once said: "For every complex problem there is an answer that is clear, simple, and wrong." I will leave it for another time, but in keeping up with this Nietzschean spirit, my guess is that we are going to suffer for a while.

Thanks for reading. Please share if you like it. Comments are welcome.

To stay up-to-date on my posts, click the follow button at the top of this post and follow me on Twitter. I tweet @rami_kiwan.