Tags: Canada, Canadian Dollar

Canada Cuts Interest Rates Despite Economic Growth

By , Money Morning •

By Mike Caggeso
Associate Editor

Canada's 25 basis point rate cut on Tuesday had many investors scratching their heads.  After all, the cut goes against conventional thinking for central banks, which often lower rates when a country's economic growth is threatened by weakening currency valuations, housing markets and/or domestic demand - none of which are currently happening in Canada.  Why cut rates now?

The answer lies with Canada's largest trading partner and neighbor to the south - the United States.

In 2006, 79% of Canada's exports went to the United States.  In September of this year, a strong economy and surging commodity prices drove the Canadian dollar to parity with the U.S. dollar for the first time in over three decades. The currency surpassed parity by 10% when it hit an all-time high of 90.58 cents Canadian per U.S. dollar on November 7th.

As the Canadian dollar strengthened against the U.S. dollar, Canada's exports became increasingly expensive for U.S. consumers.  Weakening export demands due to unfavorable conversion rates and the United States own domestic economic troubles pose a threat to Canada's economic growth.

"The Canadian economy has been growing broadly in line with the Bank's expectations, reflecting in large part underlying strength in domestic demand. However, both total CPI inflation and core inflation in October, at 2.4% and 1.8% respectively, were below the Bank's expectations, reflecting increased competitive pressures related to the level of the Canadian dollar," the bank said in a statement.

As recently as July, the Bank of Canada was concerned with inflation and raised interest rates 25 basis points.  But as the currency continued to rise versus the U.S. dollar and with lower-than-expected inflation, the Bank of Canada had every reason to reverse their position and lower rates.

Like the recent cuts in the United States, Canada's rate cut weakened its currency.  The Canadian dollar dropped a full cent against the U.S. dollar.

The Bank of Canada also cited concerns of the spreading U.S. subprime mortgage plague that has since touched down in England and Australia.

"Global financial market difficulties related to the valuation of structured products and anticipated losses on U.S. sub-prime mortgages have worsened since mid-October, and are expected to persist for a longer period of time. In these circumstances, bank funding costs have increased globally and in Canada, and credit conditions have tightened further," the bank said in a statement.

Will one rate cut do the trick?  It won't be long before we see the central bank's next move. The next interest rate decision will come on Jan. 22, 2008 - and given that the Bank of Canada cited U.S. subprime concerns in its statement, surely the Fed's decision to hold steady or cut interest rates on Dec. 11 will play a part.

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