Outlook 2008 (The watch list): Interest rates

Given concerns over credit markets and the U.S. economy, more rate cuts are likely in 2008.

In David Dodge’s penultimate interest rate decision with the Bank of Canada, the outgoing governor cut the overnight rate in December by a quarter point, to 4.25% — the first time the central bank has reduced rates since April 2004. Given the concern the Bank of Canada has shown over credit markets and an ailing U.S. economy, more rate cuts are likely in store for 2008.

In making the cut, the bank noted that while the Canadian economy was generally strong, slashing the key interest rate was necessary because of the continuing fallout from the sub-prime mortgage meltdown in the United States. Credit remains tight, and bank funding costs are up both in Canada and abroad. The American economy, particularly the housing market, has taken a beating in 2007, and that is bad news for Canadian exporters. In the third quarter, the value of exports already dropped by $3.2 billion, to $116 billion.

Sal Guatieri, a senior economist with BMO Financial Group, says the central bank became less worried about the impact of a high Canadian dollar as the loonie was hovering around parity in early December. Instead, its primary concern now is to reduce the cost of borrowing to avoid a drastic economic slowdown.

Even so, the December cut surprised some economists, who had predicted the bank would hold off reducing rates until January, since both Canada’s housing and labour markets are robust. “The logic in doing it now is that you at least get ahead of the possible recession curve,” Guatieri says. “The bank is not taking any chances.”