Insight: Looking at the overnight rate decrease

The Bank of Canada surprised many Canadians last week when it reduced the overnight interest rate from one to 0.75 per cent.

Bank of Canada governor Stephen Poloz cited plummeting oil prices as motivation behind the drop, which represents the first time the bank has changed the rate since September 2010.

“The drop in oil prices is unambiguously negative for the Canadian economy,” he said.

“Canada’s income from oil exports will be reduced, and investment and employment in the energy sector are already being cut.”

Canadian oil prices have been on the decline since late fall, with West Texas Intermediate – a U.S. grade of oil used as a benchmark for oil prices in North America – currently wavering around the $45 US mark per barrel. In turn, the Canadian dollar is close to the 80-cent mark, the lowest it’s been in six years.

While the Bank of Canada’s announcement will likely play to homebuyers’ favour, some analysts warn against using historic-low lending rates as a deciding factor when purchasing a home.

“Who it does have a potential for helping tremendously are the homeowners/homebuyers who have followed the variable rate mortgage strategy,” said Real Estate Investment Network founding partner and senior analyst Don Campbell.

The strategy entails choosing a variable rate mortgage tied to bank prime, but paying the equivalent payment as if they had locked in for five years. Payments would be higher, but extra cash paid goes directly to paying down the principal, Campbell said.

He noted the Bank of Canada’s motivation to lower the overnight lending rate was not necessarily just to stimulate the housing market, but to motivate capital spending in businesses, which in turn generates jobs as well as tax revenues.
The second reason is to lower the value of the Canadian dollar, making Canadian products – including energy, manufactured goods, forestry and agriculture – more attractive for other countries to purchase.

And the third, according to Campbell, is to help counteract a portion of dropping export prices for oil protecting more Canadian jobs as well as provincial and federal tax revenues.

Campbell said the Bank of Canada’s decision to lower the overnight lending rate is an acknowledgement the housing market is slowing.

“The housing market and mortgage rates weren’t even in the top two reasons for this drop, despite what all of the headlines are talking about,” he said.

A report from RBC Economics suggests the Bank of Canada was premature in lowering interest rates, noting oil prices will recover somewhat this year and Canada’s economy will still grow by a healthy 2.7 per cent this year.

“These factors underpin our assessment that the Bank of Canada will not need to cut interest rates further and arguably could have maintained the policy rate at one per cent,” said the report. “The sharp depreciation in the Canadian dollar in the aftermath of the Jan. 21 rate cut presents some upside risk to our forecast for export growth and core inflation.

“The Bank’s cautious approach to managing the risks to the economy and inflation suggests that it will take several quarters of above-potential growth before the Bank will begin to raise the policy rate and we expect the Bank to initiate a series of rate increases in the first quarter of 2016. Our forecast calls for the overnight rate to end 2016 at two per cent.”

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