The global credit crunch has shoved the Bank of Canada to the sidelines, prompting the central bank to hold its key interest rate at 4.5 per cent.In an unusually lengthy statement Wednesday morning, the central bank explained that the global economy is strong, and Canada's economy appears to be in overdrive for now, but the credit crunch that has rocked global markets for the past month will directly and indirectly hit the Canadian economy.
Indirectly, the U.S. housing slump that sparked the credit squeeze means near-term prospects for the American economy are weaker, and could well spill over into Canada, hurting exports.
More directly, the credit crunch will likely put a damper on borrowing activity and consumption in Canada, the bank said.
“Recent developments in financial markets have led to some tightening of credit conditions for Canadian borrowers, which should temper growth in domestic demand,” the bank's statement says.
“Against this background, the bank judges that the current level of the target for the overnight rate is appropriate.” While Wednesday's statement backed away from previous indications from the bank that interest rates would have to rise in order to keep inflation in check, it was decidedly neutral about where rates would go next.
It warned, however, that economic conditions were unusually volatile, with a heightened risk that the U.S. housing slowdown could be even worse than expected. On the other hand, there is also a big chance that consumer demand in Canada could be stronger than anticipated.
“In addition, there is uncertainty about the extent and duration of the tightening of credit conditions in Canada and hence, about the tempering effect this will have on growth in domestic demand,” the bank said.
The statement gave no indication about whether the next move for the central bank would be for rates to go up or down. And it did not officially change the bank's growth forecast for the Canadian economy, saying only that growth in the first half of the year was above its expectations.
Inflation is much as the bank had projected, slightly above the bank's target 2 per cent pace, the statement noted. “It now appears that the Canadian economy is operating further above its production potential than was estimated in July,” the statement said, promising to closely monitor economic and market developments, and publish a full economic update in October.
The statement did not make mention of the central bank's recent moves to inject liquidity into capital markets, nor did it discuss any further measures the bank may have in mind to make markets function more smoothly.
The neutral statement was widely anticipated by markets, but served to underline the uncertainty facing central banks and markets around the world.
“If August had been just a dream rather than a real-life nightmare in credit markets, the bank would surely be raising rates today to address stronger-than-expected economic growth and bubbling inflation pressures,” writes Sal Guatieri, economist with BMO Nesbitt Burns. “But the economic outlook is simply too uncertain, and the risks of a U.S. recession uncomfortably high, to entertain thoughts of tightening.”
Economists had widely expected the central bank to stand pat today.
The Bank of Canada raised its key interest rate in July after more than a year of staying at the sidelines. Inflationary pressure was increasing, and economic growth was strong, requiring an interest-rate path that rose slowly to a less stimulative level, the bank indicated.
But the credit crunch threw a wrench in that line of thinking. Two weeks ago, deputy governor Pierre Duguay said the bank was reconsidering its options because the upheaval in global credit markets could well threaten U.S. economic growth, and prompt Canadian companies to have second thoughts about their investment plans.
Until the central bank can adequately reassess both U.S. growth and Canadian corporate reaction, it would be inappropriate to change monetary policy, economists say.
But they're divided on what the bank will do next. Under normal circumstances, the central bank would undoubtedly have raised rates today, economists say. And so if the credit crunch quiets down, the bank will resume its tightening path, says Jacqui Douglas, economics strategist at TD Securities.
“We think that once all is said and done, the bank will conclude that the U.S. sub-prime market does not pose all that big of a risk to the real Canadian economy,” she wrote in a recent report. “And that can only mean one thing – a return to rate-hiking mode.”
But the credit crunch is not fading away, argues Ted Carmichael, chief economist for J.P. Morgan Securities Canada Inc. “There really hasn't been any improvement in the commercial paper market which is what people are worried about,” he said in an interview.
The problems in the short-term credit market have essentially boosted interest rates by 75 basis points (three quarters of a percentage point) for many borrowers, negating the need for the central bank to raise its key rate, and actually making a case for the bank to cut in coming months, Mr. Carmichael said.
