Bank of Canada cuts key rate in the midst of a weak economy
Loonie drops to lows unseen since 2009
In July The Bank of Canada cut their target for the overnight rate to 0.5 per cent in a move to stimulate the economy amidst steady shrinkage and falling oil prices over the first half of the year. Call it a recession, and the BoC isn’t looking positive for the rest of 2015.
Major banks cut their prime rates in response to the central bank’s announcement. Now the cost of borrowing money is a little cheaper, and financial investments have lower payoffs. Businesses and producers can finance their physical capital, like new bulldozers or buildings, and at a cheaper rate too. With these lower costs considered, firms can essentially produce more, and when more things are produced, gross domestic product goes up.
“It’s a stimulative move for the economy,” says Lance Shandler, a KPU economics professor. “It’s not a huge move, but it’s hopefully designed to do that.”
Just a crash course on the overnight rate: It’s the rate that commercial banks lend and borrow to each other so they can settle their books every night and maintain their reserve needs. They don’t need to keep massive reserves because a lending protocol at the central bank lets banks get reserves whenever they need them. Also financing reserves costs money. But since the central bank lends and borrows at rates marginally crappier than 0.5 per cent, it’s more economic for banks to deal with each other, so they do.
The central bank also targets inflation, which indicates how much you’ll pay for, let’s say, a loaf of bread. The higher it is, the less your paycheque is really worth because you end up buying less with every dollar. Right now, inflation is at one per cent, and you’re thinking, “That’s low, so that’s pretty good.” Then you might be alarmed that the target is two per cent and that’s the way the central bank is trying to move things. But a higher inflation also makes labour cheaper for firms, meaning they can produce more. It’s not as simple as saying the move by the BoC is good or bad. Shandler doesn’t see it as irregular.
“Well, for one thing it’s a rate that can be changed every six or seven weeks, so it’s not a massive change and it’s not an irreversible change,” says Shandler.
On the energy side of the economy, namely the oil and gas industries, the country is losing and some of those energy firms are projecting major layoffs.
“That has had a significant negative impact on the economy,” says Shandler. He adds that the oil and gas industries are, “Sidelined because, well, there’s no point of adding to our supplies when we can’t sell what we’ve got. So all the drilling and the exploring and all of that kind of activity, which is often left to the more junior companies, tends to be reduced, and that negatively impacts people’s incomes.”
It’s a big deal in Canada because oil is one of the country’s biggest exports. So if the world price of oil is dropping, the country’s earning less on a major export. Enter the interest rate cut. When interest rates are lower, money supply in the economy is bolstered in a way, so technically money is easier to acquire—less rare, if you will. That’s part of why the loonie has dropped to rates not seen since 2009. Relative to you, a package of steel guitar strings from California is more expensive today than it was in June; you have to compensate even more for the much more expensive U.S. dollar. But from the perspective of another country, our currency is cheaper to buy. So, Canadian oil ends up being cheaper for other countries.
It’ll take about six to eight quarters—or one-to-two years—for this interest rate cut, called expansionary monetary policy, to make its full effect on money supply.
But its effects can be felt immediately.