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The Bank of Canada (BoC) shocked markets last Wednesday when it dropped its overnight rate by 0.25% as a defensive response to sharply lower oil prices.
In its accompanying statement the Bank said that there is “considerable uncertainty” about how the oil-price shock will affect the strength of our recovery. The most immediate impacts are expected to be negative, as oil-patch investment dries up and our import purchasing power weakens. The longer term benefits of a strengthening U.S. economy and a weaker Loonie will take longer to accrue, and are thus less certain.
Against this backdrop, setting monetary policy is a daunting challenge. The BoC must make adjustments today based on assumptions about how the economy will look in the future, but with so much interplay between many complex variables, this decision-making process necessarily involves a mix of both art and science.
The BoC said it believes that “the oil price shock increases both downside risks to the inflation profile and financial stability risks”, and the Bank now expects that our economy will take until “around the end of 2016” to return to full capacity, which is later than it had previously forecast. Its rate cut is being used as a way to “provide insurance against these risks”.