The drop in interest rates announced by the Bank of Canada was a "surprise" to the markets. (5)(1) When you examine what the Bank of Canada is saying, it does not seem very surprising, but the timing of it was not forecasted prior to the announcement. (2)(3) The surprise is how quickly the Bank of Canada responded and how quickly it lowered forecasts for Canadian growth. (1) There is fear that the oil shock will have a much deeper impact than it appears.
What effect will this interest rate drop have on Canadians with respect to their government? First of all, the government has been promising tax breaks conditional on a balanced budget. This was achieved in 2014 and the tax breaks were announced. (6)(7) If you look deeper into the dynamics of the economy, much of the tax revenue is derived from exports and the oil industry in particular. When the price of oil descended rapidly, it put part of the tax revenue at risk. The drop in oil prices will have a big effect on Canada's exports and capital investment. (3)(4) Since an election is coming in 2015, and the platform for the Conservative government is based on balanced budgets, steady fiscal management and tax breaks as a result of this management, the oil price drop is critical. In order to maintain the budget and election promises, revenue must come from somewhere else. What is the fastest way to perk up an economy that has inherent risks of contracting? You lower the interest rates. The interest rate is the single biggest influence in more sectors of the economy compared to everything else, except maybe tax law or other legislation. The interest rate will increase spending wherever credit is used which is in most transactions.
Does this mean that interest rates will drop further to continue this strategy? It is very likely if oil prices stay below $50 per barrel for a year or longer. The Canadian dollar also tanked very quickly after the oil drop and the interest rate drop, which would make exports cheaper and help drive growth as well.
Will the interest rate cut save the government of Canada's budget? There are a lot of tax increases in the works and they are not jeopardized by this oil price plunge. Without revenues, the budget deficit will swoon, and it will be harder to justify the spending promises. As with all things deficit, more unemployment and spending cuts are sure to follow which will only exaggerate the layoffs in the economy.
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