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Good News for Buyers

Blog by Patrick O'Donnell PREC* | March 3rd, 2009

OTTAWA — As expected, the Bank of Canada cut its key benchmark-lending rate Tuesday by another 50 basis points, to a record low of 0.50 per cent, to spur an economy that it acknowledged is deteriorating at a faster pace than expected, and indicated it would, if required, begin buying back government bonds in an effort to stimulate the economy.

In what analysts are calling a "bold" statement, the central bank said the benchmark rate is to remain at the current level, or be cut further, until there are "clear signs" that the economy is on the path toward reaching its potential — which it now envisages won't happen until early 2010, a signal that the downturn could be longer than expected.

Most commercial banks followed the Bank of Canada's move, cutting their prime lending rates by 50 basis points to 2.50 per cent, effective Wednesday.

Both the rate cut and signals about using non-traditional means to add liquidity come on the heels of a string of dismal economic data released in recent weeks in terms of job losses, retail sales, and the current account balance. To cap it off, Statistics Canada reported on Monday that the Canadian economy shrank in last three months of 2008 by 3.4 per cent — the fastest pace in nearly two decades and deeper than the 2.3 per cent contraction the Bank of Canada had forecast in January.

"Given the scare from the latest employment figures and confirmation that the recession did start before the end of last year, the bank opted for another big hit," said Andrew Pyle, wealth adviser and markets commentator for ScotiaMcLeod.

The bank's cut was in contrast to a decision earlier Tuesday by Australia's central bank to leave its benchmark rate unchanged. The half-percentage-point cut was in line with most Bay Street analysts, although some believed it would only go another 25 basis points given its year-long moves to ease monetary policy — up until Tuesday, cumulative cuts totaling 350 basis points — and its previously-stated bullish outlook.

But in the statement explaining the rate cut, it acknowledged that its forecast from the January monetary policy update is in need of a revision.

"National accounts data . . . and other indicators of aggregate demand point to a sharper decline in Canadian economic activity and a larger output gap through the first half of 2009 than projected in January," the central bank said. (The output gap is the room between the economy's full potential and its current performance.)

"Potential delays in stabilizing the global financial system, along with larger-than-anticipated confidence and wealth effects on domestic demand, could mean the output gap will not begin to close until early 2010. These factors imply a slightly lower profile for core inflation than was projected in January."

In January, the bank forecast core inflation to ease throughout the year and return to two per cent in the first half of 2011. The bank sets monetary policy in an effort to get inflation to a two per cent target.

Now that its benchmark-lending rate is near zero, the central bank said it was "refining the approach" it takes toward adding monetary stimuli through, if required, credit and quantitative easing.

Quantitative easing, which would include the buying back of government-backed debt, is under consideration by the U.S. Federal Reserve and the Bank of England. In a note last week, economists at Scotia Capital said central banks in medium- and smaller-sized economies, such as the Bank of Canada, might feel compelled to initiate a buyback of government bonds if major central banks follow that route, out of fear that capital may flee.

The central bank is to unveil its latest economic outlook on April 23, which is expected to a framework under which quantitative easing would be executed. The outlook is also likely to update previous forecasts, which indicated the economy would shrink 4.8 per cent this quarter and one per cent in the second quarter before posting robust growth starting in the third quarter. For 2009, the economy would contract 1.2 per cent.

Douglas Porter, deputy chief economist at BMO Capital Markets, said in a note Tuesday that he expects to see "at least" three more quarters of economic decline, with a contraction this quarter of 6.2 per cent. "While we do look for growth to resume next year, our call of a 1.8 per cent advance in 2010 is a half-hearted recovery at best."

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All the best - Patrick