Rate cut highlights economic challenges

What are we to make of the Bank of Canada’s recent decision to trim its short-term policy interest rate by another 25 basis points, taking it to a near record low level of 0.5%?

The Bank is frankly acknowledging the magnitude of the energy-related downturn in capital spending and exports has been greater than expected and the pain is likely to persist. Canada is facing difficult economic adjustments stemming from a less rosy future for oil and gas markets and many other commodities.

This is unwelcome news. Natural resource industries supply more than half of Canada’s exports and helps to drive business investment in many regions of the country. A world of lower prices for energy and other commodities is a world of significantly slower growth in incomes than we enjoyed during the global commodity upcycle that began in 2002-03.

At a time of considerable macroeconomic weakness, the Bank of Canada has fallen on monetary policy to shoulder the burden of supporting aggregate demand. Fiscal policy is largely missing in action as the federal government prioritizes deficit avoidance and several provinces struggle to contain debt/GDP ratios.

Given current economic conditions and Canada’s rather uninspiring near-term growth prospects, the existing monetary/fiscal policy mix seems far from optimal, at least at the federal level.

Finally, the latest cut in the central bank’s (already low) benchmark rate signals that the conventional monetary policy tool box is now almost empty. A 25 basis-point reduction in the bank rate is too small to have any appreciable macroeconomic impact, other than to put more downward pressure on our increasingly enfeebled currency. With the policy rate set at 0.5%, the central bank has little capacity to respond to additional shocks.

It’s remarkable that, six years after Canada’s economy hit bottom at the tail end of the 2008-09 recession, the central bank’s benchmark rate sits perilously close to zero, and “real” after-inflation market interest rates are negative (or nearly so) for bank savings accounts, GICs and some other fixed income products. Few Canadian forecasters imagined, circa mid-2009, that interest rates would remain at such exceptionally low levels this far into the future considering Canada has posted several years of decent economic growth and sizable employment gains.

The way forward
While the central bank is working with the tools at hand to deliver on a mandate centred on managing inflation, trouble is being stored up as a consequence of year after year of rock bottom interest rates. Frothy housing markets and the accumulation of unprecedented household debt levels are the two most visible features of our present economic situation. It’s worth asking whether sticking with a macroeconomic policy framework that has encouraged leverage and borrowing on an epic scale while punishing thrift and prudence may be doing subtle but real damage to the long-term foundations of a productive economy.

Too large a fraction of the scarce capital and entrepreneurial talent has been directed into relatively less productive sectors and activities (housing-related investment, financial engineering, and consumer spending), while too little has been deployed to building products, technologies, skills, enterprises and infrastructure. Perhaps such a misallocation of capital and talent is the price that must be paid in exchange for relying so heavily on sustaining demand and spending during a period of sluggish global growth.

It’s too early to know how this will play out, but policy-makers would be wise to pay a lot more attention to the downside risks inherent in today’s unbalanced economy in which consumers, businesses and governments have become used to the comforts of astonishingly cheap money.

Jock Finlayson is executive vice-president of the Business Council of British Columbia. This column is distributed by Troy Media in Calgary.