Highlights
As expected, the Bank of Canada lowered its key interest rate by 25 basis points to 4 percent. The Bank had reduced its interest rate at its December 2007 meeting as well. That had been its first reduction since 2004. The Bank lowered rates amid signs the U.S., destination for about 80 percent of Canada's exports, will slide into recession. U.S. economic reports on housing and regional manufacturing (Philadelphia Fed Survey) elevated risks to the Canadian economy especially for Canadian lumber. Because of the high degree of integration in manufacturing activity in North America, the slowdown indicated by the Philadelphia Fed could point to a slowdown in Canada as well.

The Bank of Canada has an inflation target range of 1 percent to 3 percent but focuses on the 2 percent midpoint. While the overall CPI was up 2.5 percent on the year in November, the core or 'operational' CPI that is used by the Bank and excludes eight volatile items was up 1.6 percent. Manufacturing industries were particularly hard hit by the soaring Canadian currency which has cut severely into exports. At the same time the currency has made imports cheaper while shopping trips to the U.S. have replaced domestic purchases.

In its statement, the Bank said

"In the second half of 2007, the Canadian economy grew broadly in line with the Bank's expectations in the October Monetary Policy Report (MPR). Despite some slowing in growth in the fourth quarter, the Canadian economy continues to operate above its production capacity. Both core and total CPI inflation have been lower than projected in the MPR, largely reflecting a price-level adjustment related to increased competitive pressures in the retail sector stemming from the level of the Canadian dollar.

"Financial market conditions have deteriorated since October, leading to a tightening of credit conditions in industrial countries. Given this, and a deeper, more prolonged decline in the U.S. residential housing sector, the 2008 outlook for the U.S. economy is now significantly weaker than at the time of the October MPR.

"For Canada, the effects of the weaker U.S. economic outlook will lead to additional downward pressure on export growth. However, despite tighter credit conditions, domestic demand in Canada is projected to remain strong. This strength is supported by continued income growth associated with the increase in commodity prices since October, which has led to further gains in our terms of trade. Overall, the Bank now projects weaker growth in 2008 than was expected in October, with the economy moving into modest excess supply in the second quarter of this year. Somewhat stronger growth in 2009 brings the Canadian economy back into balance in early 2010. The inflation projection has also been revised down since October, especially for 2008, primarily reflecting the price-level adjustment noted above and the recent one-percentage-point cut in the GST. Both core and total CPI inflation should fall below 1 1/2 per cent by the middle of this year before returning to the 2 per cent target by the end of 2009. On the whole, the Bank judges that the risks to this inflation projection are roughly balanced.

"In line with this outlook, the Bank has decided to lower the target for the overnight rate and further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance and to return inflation to target over the medium term."