The Bank of Canada has just cut its key benchmark interest rate, the overnight rate, by 50 basis points (100 basis points = 1.00%) to 3.00%. The most recent peak for the overnight rate was 4.50% in the fall of last year.

It appears that the BOC considers Canada’s economy to be at a turning point. While many of this year’s first quarter statistics continued to perform well, signs of gathering trouble have been cropping up. On the plus side, housing starts have been remarkably strong, averaging 246,000 units in January through March, and total employment in the country has increased by 100,000 jobs in just the first quarter.

However, fissures in the wall of good news are as follows. Single-family housing starts are in decline and the strength in multiples is due to last year’s sales. Existing home sales declined significantly in the first quarter.

All three major measures of consumer spending declined in the latest reports for February 2008 on a month-to-month basis: (1) motor vehicle sales in units were -3.2%; (2) wholesale trade was -1.8% in dollar volume; and (3) retail sales were -0.7%.

The BOC’s Spring Balance of Opinion Survey
The Bank of Canada is also paying a great deal of attention to its own April 2008 Business Outlook Survey of 100 major firms in Canada. This report mainly presents “balance of opinion” measures, which are the percentage of respondents expecting an increase versus the percentage expecting a decrease, in answer to a series of questions.

The balance of opinion on future sales growth has turned negative for the first time since this question has been asked, going back to 2002. The balance of opinion with respect to more or less future investment spending on machinery and equipment has turned flat (after years of being quite positive) for the first time since third-quarter 2003.

The balance of opinion with respect to more hiring ahead is down from highs of +50 percentage points to a still-respectable level of +33 at present. The balance of opinion on input price expectations − specifically, “Will they rise faster than in the past year?” − is strongly positive.

The final survey question looks at liquidity. The percentage of those surveyed saying that the terms and conditions for obtaining financing have tightened in the last three months is now 41% versus only 17% saying that they have eased.

Anticipating the Federal Reserve Board
Besides the need to provide more stimulus for Canada’s economy, the other deal-sealer for yesterday’s action was the differential in rates between Canada (higher) and the United States (lower). Prior to yesterday, the gap had been 125 basis points. This has been a factor in keeping the Canadian dollar close to or above parity with the U.S. dollar.

The result has been tough times for Canada’s export-dependent manufacturers. Furthermore, the BOC has to be anticipating that the U.S. Federal Reserve Board will be lowering its key benchmark rate, the federal funds rate, again on April 30 (probably by 25 basis points). This is another explanation for the rather large cut in the BOC’s overnight rate.

Not all Interest Rates Respond Accordingly
Prior to the most recent interest rate cut, the overnight rate had been lowered by 100 basis points. Not all other interest rates in the economy responded to exactly the same degree. The business prime rate also fell by 100 basis points over the same period of time. However, mortgage rates only adjusted by about half. The one, three and five-year conventional mortgage rates dropped by only 40 to 55 basis points.

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