Is the Bank of Canada running out of bullets ?

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JULIAN BELTRAME Globe and Mail Report on Business The Canadian Press

OTTAWA - Just about now, Bank of Canada governor Mark Carney should be experiencing that sinking, helpless feeling about the economy.

It's not for want of trying to shock the economy back to life.

On Tuesday, the telegenic former Goldman Sachs executive is widely expected to cut short-term interest rates another half-point to bring the central bank's overnight rate to a barely-noticeable 0.5 per cent. For all practical purposes, zero.

That would make it the seventh time Mr. Carney has eased a notch, sometimes several notches, on interest rates since taking charge of the central bank last February. In that time he has also injected $40-billion in cash into the economy through asset swaps with banks, and last week took the unusual step of agreeing to accept corporate bonds as collateral to try and free up credit.

None of it has worked and the economy continues to decline.

One problem Mr. Carney faces is that in the current global credit crunch, financial market interest rates are volatile so there's no assurance Canadian banks will pass along the full Bank of Canada rate cuts by reducing their prime lending rate by the same amount.

The prime is the base used by banks to set rates on consumer and corporate loans, lines of credit and some mortgages. While the prime has dropped in most cases by the same amount as the Bank of Canada rate in the last year or so, other interest rates in the market have been rising and loans have been harder to get as the banks avoid riskier lending during a recession.

A recent survey shows a majority of manufacturers say access to credit is still the major obstacle they face.

"There is clear evidence that very low interest rates are not working to expand economic activity," former Conservative cabinet minister Doug Peters, once also a TD Bank chief economist, wrote in a paper for the Canadian Centre for Policy Alternatives.

"In the current recessionary environment, banks are obviously worried about lending to each other, and of course, are worried about lending to consumers and firms. Interest rates that count, such as inter-bank lending rates, mortgage lending rates, bank commercial lending rates, are all unusually high, especially considering that inflation is also very close to zero."

Even before Mr. Carney's Tuesday move, a new report Monday from Statistics Canada is expected to reveal that the Canadian economy, in Finance Minister Jim Flaherty's blunt words, "fell off the table" in the fourth quarter of 2008.

Private sector economists are predicting a sharp three-to-four per cent contraction in economic activity - severe recessionary territory - but remarkably it could be worse. In fact, Mr. Carney is predicting worse for the first three months of this year with a 4.8-per-cent economic contraction.

In his last public speech in January, Mr. Carney insisted that monetary action taken so far "will work," noting the lengthy lag time between action and impact, often cited as 12 to 18 months.

Since the bank started cutting 15 months ago, Canada should be just beginning to feel the effects.

Of course, Mr. Carney has invested a lot of credibility in the assertion it will work. He has stuck out his neck by predicting the economy will bounce back like an Indian rubber ball to 3.8 per cent growth next year, a forecast that has a few supporters and many detractors.

Although he doesn't believe the rebound will be as dramatic, Bank of Montreal economist Douglas Porter says there are good reasons to buy into Mr. Carney's rosy assessment, which would make the current slump milder than the recessions of the early 1980s and 1990s.

First, interest rates are much lower now than during the previous downturns. Second, aggressive stimulus policy is kicking in. And lastly, corporate balance sheets were in better shape heading into the current recession as compared to the previous two.

These act as shock absorbers for the economy's hard landing. However, they will be of little use if the world financial system is not fixed.

That's because until global banks have the confidence and wherewithal to start lending again, the U.S. and global economies will continue to struggle. And that will keep prices for commodities that Canada exports low, sap demand for Canadian manufactured goods, and in turn stifle Canadian job creation and incomes.

And that's where Mr. Carney's frustration comes in. He is largely a spectator in a game played outside his borders, able to influence the outcome only at the margins.

Mr. Carney has received some heat for some of his decisions, most notably keeping interest rates unchanged for a full five months from May to October last year in the mistaken belief that financial markets were stabilizing. But given that he's made up for lost time since then, most economists conceded the period of inaction wasn't critical.

"There are some quibbles I might have over what the Bank of Canada or Ottawa have done, but those are just specks of sand on the beach compared to what's hit us from outside this country," says Mr. Porter.

"There are things policy makers here can do to cushion the blow, but the tools at their disposal are only so big and they can only do so much to offset this deep global downturn."

In his January speech, Mr. Carney talked about other measures at his disposal besides rate cuts, no doubt foreshadowing last week's action on corporate bonds. The bank could also follow the Fed example by implementing so-called "quantitative easing" facilities to pump funds into the private sector, or follow Japan's lead by directly buying corporate bonds, or still more exotic intrusions in the money markets.

But Mr. Holt cautions non-traditional initiatives, even if Mr. Carney judged taking on the added risk necessary, would likely not be game-changing in isolation.

The next big round of central bank action should be left to the Fed and perhaps the Bank of England, he said. This could involve printing mounds of money to buy up government treasury bills in order to free up more cash for the private sector economy.

"You can cut rates to near zero, you can stimulate the domestic economy through fiscal policy, but you still need a rebound in the U.S. and European economies," he explains.

"The smart position (for Carney) is to cut rates Tuesday and wait and see what global central banks do elsewhere."