More Hacking of Interest Rates Needed

Yesterday, Canada’s central bank did its first 50-basis-point key interest rate cut in a long time. No more of the tapering off in either direction in 25-basis-point increments practiced by the former Bank of Canada Governor David Dodge. No, the talk of the town now are the “spillover” effects of the economic and, more pressingly, financial conditions in the U.S.

For years, Canada’s central bank was worried about the potential economic imbalances in the U.S. that are now threatening to throw our largest and best trade partner into the turmoil of a full-blown recession. Some voices have even raised concerns about a potential depression.

This is why the central bank has decided to cut key interest rates more aggressively than before in an effort to bring the aggregate supply and demand back in to equilibrium and maintain the two- percent inflation level over the next year or two. As a result, the Bank of Canada’s new Governor, Mark Carney, installed his first policy decision to cut interest rates by a half a percent for the first time since November 2001, while the next reset date is scheduled for April 22.

What has prompted such a radical move for the Bank of Canada? Well, some rather worrisome numbers came in; for example, the country’s gross domestic product (GDP) grew only 0.8% in the fourth quarter of 2007, which is the slowest pace in the last five years and about half of what the central bank expected.

But such disturbing GDP numbers should have come as no surprise to economists since the U.S. economy, which consumes approximately 80% of everything that Canada exports, grew even less — only 0.6% on an annual basis. Plus there are clear signs that such a slowdown is going to last much longer than until January 2009. After all, the housing market collapse was the largest in a generation, which has to have dangerous, prolonged and costly consequences.

So why did Canada’s benchmark index bleed red yesterday? First, it wasn’t alone. All North American indices were in the red yesterday, shaving off somewhere between 1.3% and two percent from their respective aggregate market caps. And the reason why stock markets, at least in Canada, didn’t even register the stimulating expansionary policy move was the onslaught of dreary economic data and even drearier corporate earnings forecasts coming in from both sides of the border.

All of this further confirms my estimate that current recovery forecasts for both Canada and U.S. are far too optimistic and will have to be pushed further into the future. I do not believe that the second half of 2008 for Canada’s recovery is realistic, just as I do not believe that January 2009 is realistic for the U.S. This is not an attempt to time the markets, since I do not believe such an endeavor even possible. It is simply taking into account important economic events as they unravel and factoring historic time frames for similar ones in to an estimate that more time will certainly be needed to re-hinge everything that has been unhinged in the recent credit-induced crisis.