Interest Rate Cut As Much Of A Gamble As Economic Policy

By: Gary Parkinson on July 19, 2015

The decision by Bank of Canada Governor Stephen Poloz to slash the overnight interest rate by another 25 basis points put the country on high alert. While no one has used the dreaded R-word, the rate cut is a warning sign that the economy is in dire straits.

Many economists criticized the central bank for lowering the interest rate, and also lobbing condemnation at the federal government for refusing to break their pre-election plans. The Conservatives have pinned their political future on balancing the federal budget, which means no new stimulus to steer Canada away from murky waters ahead.

This means monetary policy rests on Canadians using the lower rates as incentive to spend more money. The strategy runs against the numerous reports, both domestic and abroad, warning about the risks of over indebted households. The average Canadian household currently owes $1.63 for every $1 of disposable income earned in a year.

Perhaps more concerning is that the country’s largest banks are signaling the cuts to mortgage rates and other financial loans will not be as steep as the overnight rate cut. All five major banks reduced their prime lending rates by 15 basis points, 10 points shy of the central bank’s cut. Prime lending rates are the figures that impact variable rate mortgages loaned to consumers.

Angelo Melino, a onetime advisor to the Bank of Canada and now an economics professor at the University of Toronto, says mortgage rates are already hovering near record lows, leaving financial institutions little room to reduce loans any further. Speaking to reporters after the rate cut, Melino advises Canadians to expect a “muted” response from banks and mortgage brokers.

“There'll be some encouragement to borrow more, but it won't be as much as you usually get from a cut.”

Without noticeable incentive to borrow, policymakers are setting themselves up for disappointment by placing the emphasis for economic growth on the backs of homeowners. If the second half of 2015 fails to be as robust as the Bank of Canada expects, the federal government can expect even more heat by refusing to stimulate the economy with their own policies.

The next few months will be a critical time for Canada’s economic prospects moving forward.

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