Downside risks increase, but Bank of Canada keeps interest rate setting at 1%

OTTAWA -- The Bank of Canada as expected kept its trend-setting interest rate at one per cent on Wednesday, but its strong signal that it views recent economic trends negatively sent the dollar tumbling in expectation rates will remain low much longer.

Markets had anticipated the rate decision and the dovish explanation from governor Stephen Poloz, given that both the U.S. and Canadian economies underperformed expectations so far into 2014. In anticipation, markets had shaved value off the Canadian dollar versus the U.S. currency in the past two days.

Still, the dollar was sent further south after the bank statement's morning release, with the loonie losing almost one third of a cent to 91.39 US.

It has long been suspected that Poloz prefers a weak loonie as a pre-condition for an export recovery he considers essential if the economy is to enter the next phase of the recovery - one that is self-sustaining and not dependent on stimulative interest rates.

Bank of Montreal chief economist Doug Porter said the bank's statement accompanying the rate announcement supported that sentiment, even if the bank's worries about the economy are justified.

"I think everything they said is perfectly legitimate," Porter said, "and let's just say the bank is not at all unhappy today about how the currency has reacted. They continue to quietly welcome a weaker currency and they so much as said so in today's statement, without saying it."

The bank's statement was decidedly downbeat, stressing the first quarter economic under-performance in the global economy as a whole, and the U.S. in particular. Furthermore, the statement warned of further downside risks.

"Global economic growth in the first quarter of 2014 was weaker than anticipated ...and recent developments give slightly greater weight to downside risks," the bank said.

"The U.S. economy is rebounding after a pause in the first quarter, but there could be slightly less underlying momentum than previously expected."

While Poloz conceded that headline inflation had moved to his target of two per cent, he undercut the significance of the factor in his thinking about where to take monetary policy. He stressed that underlying core inflation at 1.4 per cent remained well below target and weak underlying economic growth suggests the risks to low inflation remain important.

For the Canadian economy, the bank noted that the first-quarter growth rate of 1.2 per cent was slightly lower than it had forecast, but blamed severe winter weather and supply constraints for the disappointing performance.

As it has in the past few statements, the bank is still holding out that, as the global economic recovery gathers steam, there will be increased demand for Canadian products which will spur businesses to invest in machinery and equipment and increased capacity to meet the demand.

"(Still) the ingredients for a pickup in exports remain in place, including the lower Canadian dollar and an anticipated strengthening of foreign demand," the bank said. "Improved corporate profits, especially in exchange rate-sensitive sectors, should also support higher business investment in the coming quarters."

That hasn't happened yet -- first quarter exports were down, as was business investment.

And there was additional bad news Wednesday coming out of Statistics Canada. The country slipped back into a trade deficit in April of $638 million, as exports fell by 1.8 per cent.

Most economists believe the statement changes little as far as monetary policy, with the consensus view that Poloz would need to start raising rates in the second half of 2015.

But it was a good day for rate doves, as the markets acknowledged.

"Overall, the policy statement is consistent with our long-held view that interest rates will have to remain low for longer than the consensus view," said David Madani of Capital Economics.

Madani pointed out that the central bank's hope for a revival of business investment has till now been frustrated with firms banking their profits. And with the key housing sector likely to drag down the domestic economy, he wondered from where the growth going to come from.

Madani has not ruled out a rate cut in the future, if his minority view about the economy hold true.

What may have held the bank back from further reducing borrowing costs -- which would have the effect of stimulating the economy by making it more attractive for households and businesses to borrow and spend -- is the fear that the housing market will tip into bubble territory. As well, the bank has warned households against taking on excessive debt they may not be able to service once rates start rising.

But those concerns are subsiding. The bank noted it is no longer as worried about housing and household debt as it once was, although debt remained at elevated levels.

"There are continued signs of a soft landing in the housing market and a constructive evolution of household imbalances," it said.