Understanding Why Mortgage Rates Are Dropping

The Bank of Canada announced a surprise quarter-percentage-point cut to its key interest rate Wednesday – a move it calls “insurance” against the potentially destructive effects of the oil price collapse. The reduction in the bank’s overnight rate to 0.75 per cent from 1 per cent – its first move since September, 2010 – comes as a precipitous drop in the price of crude slams Canada’s oil-dependent economy.

Speaking to reporters, Mr. Poloz said the oil price drop is “unambiguously bad” for the Canadian economy, prompting the bank to take out what he called an “insurance policy” against future risks, such as weak inflation and a household debt squeeze. But he denied the move was calculated to send the Canadian dollar lower.

“Market consequences will be what they are,” he said.

The rate cut sent the loonie plummeting below 81 cents (U.S.).

Mr. Poloz, who acknowledged that oil dominated the bank’s discussions leading up to Wednesday’s rate decision, said he’s ready to cut rates again if prices fall further.

“The world changes fast and if it changes again, we have room to take out more insurance,” he said.

The rate move, which few analysts anticipated, is an attempt by Mr. Poloz to shield highly indebted Canadian households from an oil-induced hit to their jobs and incomes – signs of which are already evident in Alberta.

The rate cut is a signal to private-sector banks to lower their own rates on mortgages and other loans.

Cheaper crude, while good for the U.S. and global economies, is unequivocally bad for Canada.

The bank warned that lower oil prices would take a sizeable bite out of economic growth in 2015, delay a return to full capacity and hurt business investment – a trend that has already triggered mass layoffs and production cuts in Alberta’s oil patch.

But the effects could spread further, threatening financial stability as a result of possible losses to jobs and incomes, according to the central bank.

“The oil price shock increases both downside risks to the inflation profile and financial stability risks,” the bank acknowledged in a press release. “The Bank’s policy action is intended to provide insurance against these risks.”

The bank’s new forecast assumes a price of “around” $60 per barrel for Brent crude, more than $10 above where it is now. But the central bank said prices “over the medium term are likely to be higher” than $60.

As recently as June, oil was selling for $110 a barrel.

The bank also lowered its bank rate and the deposit rate by a quarter percentage point Wednesday, to 1 per cent and ½ per cent, respectively. And it removed any indication of which way rates might go next.

The bank’s decision coincides with a much more pessimistic economic forecast than the bank issued just three months ago.

Following the lead of most private-sector forecasters, the bank slashed its GDP growth forecast to 2.1 per cent this year (from 2.4 per cent), before rebounding to 2.4 per cent in 2016. The worst effects of the oil collapse will be felt in the first half of this year, when the bank expects annualized growth of 1.5 per cent, nearly a full percentage point lower than its October forecast.

The Canadian economy grew at an estimated rate of 2.4 per cent in 2014.

The bank said the economy won’t return to full capacity until the end of 2016, several months later than its previous estimate of the second half of next year. Among other things, the central bank pointed to significant “labour market slack.”

Crude’s effects on the economy will be broad and profound, the bank warned. Investment in the oil and gas sector will decline by as much as 30 per cent this year, while lower returns on energy exports will eat into Canadian incomes, wealth and household spending.

The bank also hinted at a possible spread to other parts of the country of a real estate slump already under way in Alberta. “The extent to which the downturn already evident in Alberta will spill over into other regions remains to be seen,” the bank pointed out in its monetary policy report.

“The ramifications of the oil-price shock for household imbalances will depend importantly on the impact of the shock on income and employment,” the bank added.

The bank also expressed growing angst about the impact that oil could have on inflation, which it said has been propped up by temporary effects, such as the “pass-through” effect of the lower Canadian dollar.

Consumer price increases, now running at roughly 2 per cent a year, are “starting to reflect the fall in oil prices,” the bank said.

The bank’s new forecast calls for overall inflation to fall well below its 2-per-cent target this year, averaging just 0.6 per cent. Core inflation, which strips out volatile food and energy prices, is expected to average 1.9 per cent in 2015.

Source: Globe and Mail