January 25, 2008

• Fed stuns with a 75 bps emergency interest rate cut; BoC trims rates by 25 bps
• U.S. rate cut curbs stock market plunge

The recent carnage in equities had the markets crying “uncle” and judging from the Federal Reserve’s surprising 75bps interest rate cut earlier in the week, their pleas were heard.

In a dramatic and surprising move that reflected serious concerns about a deteriorating U.S. economy, the Federal Reserve slashed its key interest rate by three-quarters of a percentage point to 3.50% on Tuesday – a week before its January 30th meeting date. At a scheduled meeting the same day, the Bank of Canada also cut rates, but by a more measured 25bps. For the U.S. central bank this marked the biggest reduction in the federal funds rate since October 1984 and is the first such cut between meetings since September 17th, 2001. The action followed a plunge in financial markets around the world, as foreign investors expressed alarm that tightening credit in the U.S. could stifle economic growth worldwide. The Fed’s decision was, thus, an attempt to address mounting signs of economic trauma and to try to restore calm to investors sentiment. The cut certainly pepped up global stock markets. With triple-digit index gains on Thursday, North American stock markets appear set for more advances at the end of this roller-coaster week. The Dow Jones industrial average closed up108.44 points yesterday, while, in Canada, the S&P/TSX composite index gained 249.87 points after dropping more than 600 points on Monday.

U.S. economy on the ropes

U.S. economic conditions have deteriorated rapidly in recent weeks. Existing home sales in the U.S. fell dramatically in December (-2.2% m/m), capping the biggest yearly slump (-12.8%) on record in more than a generation. 2007 also recorded the first ever annual decline (-2.8%) in the prices of existing single family homes in at least four decades. With home prices falling steadily and foreclosures likely to climb further amid rising mortgage rate resets, housing shows no sign of bottoming. The seemingly endless descent in the housing market is starting to seep into other sectors and, along with record high energy prices, is weighing on consumer sentiment. Credit conditions continue to tighten due to the massive debt write-downs at financial institutions. This, along with the recent steep slide in global equity markets early in the week, compounded the souring of sentiment. Employment – the last pillar of consumer support – is now giving out, with nonfarm payrolls recording the slowest growth in four years last month, lifting the unemployment rate to a two-year high of 5%. Not surprisingly, the holiday shopping season ended in a Scrooge-like fashion.

Clearly, the downside risks to U.S. economic growth have increased considerably and the Fed responded with a bold 75bps inter-meeting rate cut on Tuesday.

The Fed’s decision, coupled with plans underway to inject fiscal stimulus, shows a strong commitment from the U.S. authorities to try and address the current market distress and associated downside growth risks. We are hoping that the prompt and decisive actions shown by policymakers will help the U.S. avoid an all out recession. Nonetheless, the risks have definitely become acute. Indeed, U.S. real GDP is expected to advance by a mere 1.2% (annualized) in the first half of the year. Clearly, it would not take much for the downside risks to lead to back-to-back contractions in real GDP that would meet the technical definition of a recession. The Fed is well aware of this and will likely take further monetary action to ameliorate the situation. We look for an additional 75 bps in rate cuts from the Fed over the next two meetings (50 bps next week and 25 bps on March 18th), bringing the fed funds rate to 2.75%. The good news is that these hefty Fed rate cuts (175 bps so far and quite possibly 225 bps come Wednesday) should start to revive growth in the second half of 2008. The rate cuts should help lower the extent of upcoming ARM resets and directly lower mortgage costs. Lower mortgage rates, in turn, could help put a floor under home sales and ultimately help with a recovery in consumption.

In contrast to the Fed’s aggressive approach, the Bank of Canada maintained a measured approach to easing this week. The Bank cut its policy rate 25 bps to 4.00% – a move that had been widely expected. However, the deep swoon in global stock markets earlier in the week and the Fed’s surprise inter-meeting rate cut, just moments before the Bank’s announcement, had pumped expectations of a more aggressive 50 bps cut. Nevertheless, the Bank decided to stick to the script, reflecting their confidence in the Canadian economy’s ability to weather the U.S. downturn. The slowdown stateside will, however, have obvious negative ramifications for Canada’s exports to the U.S., which account for a sizeable 23% of Canadian GDP. This along with tighter credit conditions at home prompted the Bank of Canada to chop their growth and inflation outlook for 2008 in the MPR update on Thursday. The Bank now expects U.S. growth to average just 1.5% in 2008 (versus 2.1% previously), while the Canadian economy is expected to rise 1.8% this year, well below the 2.3% gain it had previously predicted.

In addition, the Bank took an ax to its inflation forecasts, reflecting the projected emergence of modest excess supply by mid-year, the inflation damping impact of the elevated loonie, and the implementation of the GST cut. Both total and core inflation are expected to fall below 1.5% by mid-year, before returning to 2 % by the end of 2009. Indeed, today’s December CPI figures for Canada showed that the core CPI growth rate was already at a 1.5% y/y pace and that the 3-month annualized trend was in fact below zero, at -0.4%. This leaves the core index with a 1.6% pace during Q4, identical to the Bank’s estimate from the MPR Update. This decline in inflation should continue in 2008 and will allow the Bank of Canada to push inflation concerns to the back burner as worries over further weakness in the U.S. spilling over into Canada dominate the economic dialogue. The inflation report supports the notion that the Bank has maximum flexibility to respond to growth risks over the coming months, and is one of the key reasons why we see the Bank continuing with its rate cut campaign in the first half of 2008, cutting by an additional 75bps over the next two meetings (50 bps on March 4 and 25 bps on April 22). This will bring the overnight rate to 3.25%. However, there was little in the MPR to hint that they are poised to come close to matching the very aggressive cuts seen from the Fed so far. Unlike our neighbors to the south, Canada’s domestic demand platform is fundamentally sound. Indeed, November retail sales out earlier in the week doubled expectations (+0.7%, +1.7% ex-autos), consistent with still-strong consumer spending.

Ritu Sapra, Economist
416-982-6420

Recent TD Economics Research