As an oil exporter, Canada's economy is being hit hard by the over 50 percent plunge in oil prices since June and the Bank of Canada (BOC) lowered its 2015 forecast for growth and inflation, estimating that the fall in oil would reduce expected growth by 1.0 percent by the fourth quarter of 2015 and by 1.4 percent by the end of 2016.
The shock to Canada's economy from the plunge in oil prices is occurring against a backdrop of improving economic growth, but the BOC said investments in the oil sector - which accounts for 30 percent of the country's total business investment - will decline and domestic demand will suffer while inflation is already starting to reflect the fall in oil prices.
"The Bank's policy action is intended to provide insurance against these risks, support the sectoral adjustment needed to strengthen investment and growth, and bring the Canadian economy back to full capacity and inflation to target within the projection horizon," the BOC said.
The BOC cut its forecast for annual growth of Gross Domestic Product in the fourth quarter of 2015 to 1.9 percent from 2.4 percent in its previous forecast from October but raised the forecast for fourth quarter 2016 growth to 2.5 percent from 2.2 percent as the negative impact of lower oil prices is gradually mitigated by the stronger U.S. economy, a weaker Canadian dollar and the rate cut.
The forecast for consumer price inflation was lowered to 1.2 percent by the fourth quarter of 2015, down from October's forecast of 1.8 percent, while the forecast for the fourth quarter of 2016 was unchanged at 2.0 percent.
Canada's headline inflation rate eased to 2.0 percent in November from 2.4 percent in October while its GDP expanded by 0.7 percent in the third quarter of 2014 for annual growth of 2.59 percent, up form 2.54 percent.
Although the rate cut took economists and financial markets by surprise, analysts had already pushed back their expectations for a BOC rate rise to 2016 from mid-2015 and lowered their forecasts for the Canadian dollar due to the impact of lower oil prices.
The Bank of Canada issued the following statement:
"The Bank of Canada today announced that it is lowering its target for the overnight rate by one-quarter of one percentage point to 3/4 per cent. The Bank Rate is correspondingly 1 per cent and the deposit rate is 1/2 per cent. This decision is in response to the recent sharp drop in oil prices, which will be negative for growth and underlying inflation in Canada.
Inflation has remained close to the 2 per cent target in recent quarters. Core inflation has been temporarily boosted by sector-specific factors and the pass-through effects of the lower Canadian dollar, which are offsetting disinflationary pressures from slack in the economy and competition in the retail sector. Total CPI inflation is starting to reflect the fall in oil prices.
Oil’s sharp decline in the past six months is expected to boost global economic growth, especially in the United States, while widening the divergences among economies. Persistent headwinds from deleveraging and lingering uncertainty will influence the extent to which some oil-importing countries benefit from lower prices. The Bank’s base-case projection assumes oil prices around US$60 per barrel. Prices are currently lower but our belief is that prices over the medium term are likely to be higher.
The oil price shock is occurring against a backdrop of solid and more broadly-based growth in Canada in recent quarters. Outside the energy sector, we are beginning to see the anticipated sequence of increased foreign demand, stronger exports, improved business confidence and investment, and employment growth. However, there is considerable uncertainty about the speed with which this sequence will evolve and how it will be affected by the drop in oil prices. Business investment in the energy-producing sector will decline. Canada’s weaker terms of trade will have an adverse impact on incomes and wealth, reducing domestic demand growth.
Although there is considerable uncertainty around the outlook, the Bank is projecting real GDP growth will slow to about 1 1/2 per cent and the output gap to widen in the first half of 2015. The negative impact of lower oil prices will gradually be mitigated by a stronger U.S. economy, a weaker Canadian dollar, and the Bank’s monetary policy response. The Bank expects Canada’s economy to gradually strengthen in the second half of this year, with real GDP growth averaging 2.1 per cent in 2015 and 2.4 per cent in 2016. The economy is expected to return to full capacity around the end of 2016, a little later than was expected in October.
Weaker oil prices will pull down the inflation profile. Total CPI inflation is projected to be temporarily below the inflation-control range during 2015, moving back up to target the following year. Underlying inflation will ease in the near term but then return gradually to 2 per cent over the projection horizon.
The oil price shock increases both downside risks to the inflation profile and financial stability risks. The Bank’s policy action is intended to provide insurance against these risks, support the sectoral adjustment needed to strengthen investment and growth, and bring the Canadian economy back to full capacity and inflation to target within the projection horizon."
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