The key policy-setting interest rates of the Federal Reserve and the Bank of Canada both now stand at 4.25%. The Bank of Canada (BOC) cut its target overnight rate by 0.25 percentage points on December 4th and a week later, on December 11th, the Federal Reserve’s Open Market Committee (FOMC) dropped the federal funds rate by a similar 25 basis points (100 basis points = 1.0%).

The Bank of Canada’s move was in anticipation of what the Fed would be doing. There were two primary reasons behind the BOC’s action. (1) To ensure that the value of the Canadian dollar would not increase further versus the U.S. dollar. This would further harm export sales and becomes even more important in connection with the second point. (2) To provide stimulus for Canada’s domestic economy in the event of a significant slowing in the U.S. economy in the year ahead.

Reasons Behind Fed Move More Complicated
The reasons behind the action taken by the Federal Reserve were more complicated. Furthermore, the Fed’s move contained an element of surprise in that many economy watchers had expected a 50 basis point cut in the federal funds rate. The subprime mortgage crisis has morphed into a bad debt crisis.

What started as a problem for low wage earners has blown up into a much bigger problem for financial institutions with collateralized debt obligations (CDOs) in their portfolios. There is now a perception that many financial institutions will have to deal with significant writedowns of their assets. The consequent need to bolster reserves has cut into lendable funds. Liquidity is being squeezed by risk aversion on the part of lenders. With the globalization of financial markets, this has become an international phenomenon.

Steps by central bankers around the world are being taken to ensure that adequate funds will be available to borrowers with legitimate needs and proper credit. Lowering interest rates and pumping money into the system is one answer. Taking proper account of loan losses in upcoming financial statements will be another. The final component will be the psychological boost that will come with better economic news. On this final point, the Fed reduced its key rate by only 25 basis points rather than 50 because many of the major indicators on the U.S. economy remain strong or only slightly down (and an end to the housing slump may be within sight.)