Sluggish Growth and Interest Rates

Canadian growth numbers were released this week and our GDP shrank by 0.1%  in April.  It also shrank in three months before April.  An official recession is when an economy contracts for two quarters in a row. This is bad news for the current government because it means that if we were to go into a recession it would be right about the time there is supposed to be an election call.  The Conservatives can delay calling an election to see if they can get some positive numbers but then the NDP and Liberal will certainly call them out on it. For a government that keeps talking about how strong they have made the economy, it would be a disaster.   This also means that the Bank of Canada could consider dropping its overnight rate again before the year end.

There has been at least one economist interviewed by the National Post saying he believed the BoC would drop from the current target overnight rate of 0.75% to 0.25%.  When we are looking at such low rates we must keep the BoC operating band in mind.  If the BoC wants the overnight rate to be 0.75%, as it does at the moment, then it pays 0.5% on deposits and charges 1% interest on any overnight loans.  This means that no bank would borrow from anywhere else at more than 1% and would not lend to any other bank at less than 0.5% interest.  This creates the desired overnight rate of 0.75% with an operating band of 50 basis points.

If the BoC were to lower its rate by 0.5% (or twice by 0.25%) that would mean it pays 0% on all deposits. That is a pretty drastic step because if you find yourself in need of more stimulus after the 0% lower bound you must move to more quantitative easing or you could follow what the European Central Bank did last year and move into negative interest rates.  Essentially the BoC would penalize any deposits the banks held with them overnight.

So expect another quarter point rate drop before the end of the year unless Stephen Harper gets his wish and we see a nice turn around in the next few months.

Please type what you think and why.