Why the BoC’s rate cut isn’t working

For months now, Bank of Canada Governor Stephen Poloz and an accompanying chorus of economists have been predicting that the second quarter would be turnaround time.

Yes, the first quarter stank, thanks to the oil price shock. But in the second quarter, the “insurance” the bank took out in January — a 0.25-per-cent rate cut — would have had time to work its magic, exporters would start picking up the slack in the oil patch, and the tide would turn.

Well, now we know that’s pretty much a pipe dream.

Statistics Canada released its gross domestic product re- port this week, and it showed that GDP fell by 0.1 per cent in April. Just about every economist in the land had been predicting at least a modicum of growth as the first step in a rebound from a dismal first quarter during which GDP shrank by 0.6 per cent.

The rebound didn’t happen. And it very well may not happen in May and/or June. If it doesn’t, then we’ll have two consecutive quarters of contraction. Which, technically, is a recession.

This raises one obvious question and one not-so-obvious one. The first is, why are we here? That is: How come the “insurance” Poloz took out in January doesn’t seem to be working, at least not yet?

There are quite a few answers for that.

First, it’s probable that economists underestimated the impact of lower oil prices. There is also the on-again, offagain recovery in the United States, which was supposed to be growing like gangbusters (relatively speaking) by now. Hasn’t happened. Manufacturing in China, meanwhile, has slowed, which has kept commodity prices down.

And then there’s the recalcitrance of Canadian companies when it comes to investing in their businesses. This would be particularly important in the manufacturing sector, where capacity shrank through a decade of high oil prices, and which would need to ramp up spending to meet increasing U.S. demand (which, you know, hasn’t really happened).

Under the rebound scenario, lower interest rates should incentivize businesses to invest. Yet capital investment remains weak, and manufacturing’s contribution to GDP actually fell by 0.2 per cent in April.

It could be because interest rates are already so low that the reduced cost of debt capital isn’t spurring more investment. Maybe companies just aren’t seeing the return on even cheap money.

In any case, businesses built up a lot of inventory over the winter, so it’s not like they have to produce more in anticipation of future demand. It’s smarter to just wait and see.

And that, in a way, leads to a less obvious question: If we’re heading into or already in a recession, how come it doesn’t feel that way?

That’s a subjective question. But consumer confidence has been strong even as the economy swooned. Job growth is okay, too. The average Canadian is feeling pretty good about things and why not?

Canadians are getting richer while the economy is getting, er, poorer. According to Statscan’s mid-June national balance sheet report, per capita household net worth rose by 3.2 per cent in the first quarter. Some of that gain has to do with real estate, but non-financial assets rose by only 1.2 per cent in the first quarter, while financial assets — pensions and mutual funds, that sort of thing — gained 6.2 per cent.

Even though Canadians borrowed more money in the quarter, the ratio of total household debt to assets fell. Just like it has ever since 2009. By the way, April 2009 is when the Bank of Canada brought in the last 25-basis-point rate cut in response to the global recession — or rather, the last one until this January.

Last week, Poloz said at a conference held by the Bank for International Settlements that his January rate cut was like emergency surgery, necessitated by the oil-price shock. “If the doctor says you need surgery to avoid death, the side effects don’t usually deter you,” he said.

But one of the side effects of monetary easing is asset-price inflation, about which the Bank has occasionally expressed concern, as have the Organisation for Economic Co-operation and Development and the International Monetary Fund in more alarmist terms. Despite all the warnings, Canadians still seem quite happy to buy houses and invest in the stock market.

What we have here is a situation: Neither businesses (who should be spending) nor consumers (who should stop borrowing money, dammit!) are doing what they’re supposed to do. And for perfectly rational reasons.

After this week’s bad GDP data, economists have moderated their predictions and are now giving more weight to the likelihood of another rate cut.

Maybe next time it will work the way it’s supposed to.