Central bank says Canada in recession, slashes key rate to 1.5 per cent

OTTAWA - The Bank of Canada took an axe to short-term interest rates Tuesday, warning of a deteriorating global economy and declaring for the first time that Canada has stumbled into a recession.

The lower interest rates, if passed on by the commercial banks, will make it less costly for businesses and households to borrow for expansion and consumption. Such spending boosts economic growth and provides jobs to stimulate the recessionary economy.

But it appears the commercial banks will not pass on the full three-quarters of a point cut by the Bank of Canada, which lowered its overnight rate to the lowest level in half a century at 1.5 per cent.

For many years, Canadian banks maintained a consistent spread between their prime rate and the Bank of Canada's overnight rate but recently they have sometimes allowed the gap to widen.

But TD Bank (TSX:TD) -- the first to react to the central bank's move -- said Tuesday it would trim its prime lending rate by half a point to 3.5 per cent.

Most of the other major banks followed suit with a half-point cut to their prime rates, which sets the bar for many business and consumer loans, including open mortgages.

In early October, the chartered banks also balked at passing through fully the Bank of Canada's rate reduction but later made up the difference when Ottawa agreed to buy $25 billion in mortgage assets off their books.

The central bank's dramatic chop to the overnight rate Tuesday was the largest since October 2001 in the aftermath of the 9-11 terrorist attacks.

The bank said dramatic action was needed given the rapidly deteriorating global economy and the impact of the financial crisis and plummeting commodity prices.

"The outlook for the world economy has deteriorated significantly and the global recession will be broader and deeper than previously anticipated," it said in a statement accompanying the decision.

"While Canada's economy evolved largely as expected during the summer and early autumn, it is now entering a recession," it added.

"The recent declines in terms of trade, real income growth, and confidence are prompting more cautious behaviour by households and businesses."

A recession is commonly defined as two consecutive quarters of economic shrinkage and by that measure Canada has avoided a recession this year since there was growth in the third quarter.

However, given a sudden drop in economic activity that began in October and prospects of continued slowdown throughout early 2009, many economists have said Canada's recession has begun in earnest.

Although most private-sector analysts had predicted a half-point cut from the central bank, Scotia Capital economist Derek Holt praised it for rising to the needs of the economy.

Given the "dovish" tone of the bank statement, Holt said Canadians should expect another half-point cut at the next scheduled rate decision date on Jan. 20. He said it is possible the overnight rate -- the rate banks charge each other on one-day loans -- will fall below one per cent by late winter.

"Beforehand, they were criticized for not being aggressive enough but now they have come around," Holt said.

Tuesday's statement was the first in which the Bank of Canada was unequivocal that the country had fallen into a recession. The closest that governor Mark Carney had come previously was last month when he said recession was a distinct possibility.

Since then the vast majority of economic indicators have been in retreat, including retail sales, auto purchases, housing starts and prices, commodity prices -- and dramatically -- last month's 70,600 shrinkage in jobs.

The central bank's move was partly a "catch-up" after it did not cut rates more deeply in October, and was urgently needed because of the lack of economy-boosting spending by the Conservative federal government, commented IHS Global Insight economist Dale Orr.

"Today the cry for fiscal stimulus for Canada is loud and clear," Orr wrote.

"Instead of examining what the government could do to stimulate the economy facing such difficult times, the government opted to try to present a balanced budget."

Although monetary and fiscal stimulus differ in the manner they boost growth, Orr said interest rates cuts are preferred by economists because their impact is quicker and can more readily be reversed when the economy recoups.

Prime Minister Stephen Harper and Finance Minister Jim Flaherty have said they will present a stimulus package in the budget scheduled for Jan. 27 -- although the opposition parties have called for more speedy action and had threatened to topple the minority government over perceived inaction.

Given the lag time needed to get major infrastructure projects started, Holt said it was essential for the Bank of Canada to show leadership because Ottawa's stimulus --when it comes -- may not impact the economy for another year.

Lower interest rates, if passed on by the commercial banks, encourage businesses and households to borrow for expansion and consumption.

The central bank will not publish new projections for the economy until Jan. 22, just days before the next federal budget.

In its new outlook, IHS Global Insight projects the Canadian economy will shrink 0.4 per cent in 2009 and full recovery would not occur until late 2010.

The Bank of Canada did not predict how long the slump will last but said bold actions by governments and central banks, especially in the United States and Europe, are beginning to loosen up money markets and support world economic growth.

It said other factors are helping Canada counter the economic slowdown, including the depreciating loonie which is making exports more competitive.

After the rate reduction, the currency fell by more than a cent to below 78 cents US. but gained back some of the loss in later trading.