In President Obama’s State of the Union message that he delivered to a joint session of congress on Tuesday, January 20, he stated that the “shadow of the (economic) crisis has passed” in the United States. The very next day, the Governor of the Bank of Canada dropped interest rates by 0.25 percent “to stave off emerging risks such as weak inflation and a real-estate downturn.” The rate cut, the first by a Group of Seven country in the face of oil prices that have tumbled to about $46 (U.S.) a barrel from $110 last June, caught financial markets off guard. The Canadian dollar plummeted about 1.5 cents to close at 81.07 cents.
This raises a number of questions. First, are the economies of Canada and the United States that different? As two large trading partners that share the largest unprotected border in the world, why has the U.S. signaled that the recession has passed while Canada has highlighted its fears of falling backward into a downturn?
It is interesting that this announcement comes as the manufacturing sector in eastern Canada revs up. Anecdotal evidence from truckers (in eastern Canada) suggests that freight volumes are strong for the month of January, stronger than in prior years. Why make this move and why make it now?
There are two ways to frame the move by Steve Poloz, the Governor of the Bank of Canada. One could look at yesterday’s announcement as an act of desperation, as the sign of a country that blinked first in the face of the challenges facing the energy industry. While we have been receiving hints of increases in interest rates for some time, this action runs contrary to expectations. It may signal a worry, possibly based on early reports of layoffs and cancelled capital expenditures in the energy sector, that the Bank of Canada had to do an “about face” and take dramatic action to counter this potential threat to the economy. Of course, this also signals Canada’s overdependence on energy, that we have two many “eggs in one basket” and that our economy is nowhere near as diversified as the American economy.
Clearly the quick drop in the value of Canadian dollar is unsettling and may not instill confidence in the Canadian government, the BOC, our currency or the Canadian economy. The central bank warned that lower oil prices would take a sizable bite out of economic growth in 2015, delay a return to full capacity and hurt business investment – a trend that has already triggered layoffs and spending cuts in Alberta’s oil-and-gas industry. Canada’s two-speed economy is undergoing a major reversal of fortunes, with the once-booming energy sector fading while the manufacturing sector is rebounding, Mr. Poloz said. Economist David Madani of Capital Economics said that “clearly, [the BoC] is far more worried about a severe housing market correction.”
A second way to way to assess yesterday’s surprise rate cut is as a proactive, pre-emptive, clever strike to lower the value of the dollar as a means of igniting cross-border trade with the United States and other countries. An 81 cent dollar or a sub-80 cent dollar would boost Canadian manufacturing. This may offset the punishment to the energy sector and to the Canadian economy as a whole. Mr. Poloz, in his second year as Governor of the Bank of Canada, may have played his cards by stating that he acted now to make sure the rate cuts get to work fast, adding that he’ll cut again if crude prices fall further. “The world changes fast and if it changes again, we have room to take out more insurance.” Recent reports have suggested that the price for a barrel of oil may fall as low as $20 or $30 before it begins a slow recovery that may take several years to play out.
Hopefully President Obama was correct in stating that the U.S. recession is over. Hopefully, the BOC acted on sound data and that this action will allow the Canadian economy to offset the damage from the turbulence in the energy sector and move forward, in a vigorous, stable and robust way.
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