January 21, 2015 11:07 am
Updated: January 21, 2015 9:10 pm

Plunging oil prices prompt sudden rate cut from Bank of Canada

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WATCH: Eric Sorensen explains why the Bank of Canada made the surprise interest rate cut and why it matters to you.

The Bank of Canada stunned economy experts and financial markets on Wednesday by cutting its benchmark overnight interest rate by one-quarter of a percentage point, to 0.75 per cent.

That might not sound like much, but the surprise move is the wrong direction financial experts want rates headed in as consumers confront record debt loads. A fresh cut to interest rates will encourage more borrowing.

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The immediate risks for the national economy presented by plunging oil prices however outweigh consumer debt considerations, according to the bank.

“This decision is in response to the recent sharp drop in oil prices, which will be negative for growth and underlying inflation in Canada,” it said in a statement.

Canada’s central bank is responsible for influencing interest rates charged by private banks and lenders, as well as managing other high-level monetary matters to keep the financial system and broader economy stable.

“The Bank was obviously spooked by the collapse in oil prices,” Canadian economists at Capital Economics said following the decision.

MORE: Here’s what’s keeping Canada’s central bankers up at night 

Oil’s impact

Experts and economy watchers had been expecting the central bank to hold its trend-setting rate at 1.0 per cent, where it has been since September 2010.

But economic conditions appear to be deteriorating as oil prices have collapsed — down 55 per cent since the summer. Big Canadian energy firms have scaled back investments for this year while some have begun laying off workers in recent weeks.

Oil extraction accounts for about 3 per cent of Canada’s total economic output (GDP) while crude represents about 14 per cent of exports. But the sector is intertwined with several areas of the economy, helping to support regional housing markets and services that feed into oil development.

WATCH: The Global News panel discusses what the dollar will do as the price of oil plunges.

More borrowing ahead

A rate cut means big banks and other lenders are likely to lower their own interest rates charged to borrowers, encouraging Canadian consumers and businesses to take on more credit.

The rate cut is surprising given the fact Canadian households are already carrying record-high debt burdens – the biggest domestic risk to the economy, according to experts, including the Bank of Canada.

MORE: Canadians pile on more debt, as U.S. households pay it down

In cutting its key rate, the bank must consider the near-term economic risks presented by diving oil prices as being greater than the risks posed by overly indebted households.

At a press conference, Bank of Canada Governor Stephen Poloz acknowledged the  rate cut will stimulate more borrowing, posing a greater risk “at the margins.”

But the risk to employment and other economic consequences from the “oil shock” are greater, he suggested.

MORE: Rate cut isn’t a green light for consumers to borrow more, experts say

Lowered outlook

Economic growth for 2015 was revised lower by the Bank of Canada on Wednesday, with the economy expected to expand 2.1 per cent compared to the bank’s previous estimate of 2.4 per cent.

That estimate relies on oil prices of $60/barrel. If oil prices remain at their current lows, economic growth will come in under that projection.

Lower rates will provide a jolt to the economy in a few ways.

More borrowing among businesses and households will spur more spending and consumption. Lower rates also push the Canadian dollar lower, providing a boost to sectors like manufacturing.

Canadians will also be encouraged to spend more money inside the country, providing a lift to tourism and service industries.

The rate cut means the oil shock to the economy has been diffused into merely a “setback” for the economy, Poloz said, rather than something more serious like a recession.

jamie.sturgeon@globalnews.ca

WATCH: Highlights from the Bank of Canada’s announcement on its interest rate cut.

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