Analysis

Interest rate cut doubles effect of falling oil price: Don Pittis

In many ways the plunge in oil prices mimics the effects of an interest rate cut. With today's surprise rate rate cut of his own, our chief central banker will help the oil-producing areas of the country, but he risks overheating when the double stimulus finally hits.

Double stimulations may feel good, but they may double the hangover

After years in the doldrums, manufacturers in central Canada will benefit from the stimulus of lower interest rates and cheaper energy, but there is a danger of a hangover. (Canadian Press)

(Editor's Note: this column has been updated to incorporate Wednesday's interest rate cut, but its message remains essentially the same.)

The Canadian dollar has been falling. Inflation is down to the point where many countries are worried instead about deflation. The economy has been getting a boost as the cost of doing business and the cost of living both fell.

Normally we'd associate all these things with a cut in interest rates. Low inflation opens the door to cuts. But until today the cause has been falling oil prices. Now the Bank of Canada governor Stephen Poloz has doubled down on the stimulative effect with a surprise cut in rates.

Once it kicks in, this double stimulation should perk up the Canadian economy. But like drinking beer with shots, it may also double the hangover.

In some ways and in some parts of the country falling oil prices are a big improvement on rate cuts, chief of which is that lower oil does not force people or businesses to borrow more money to get the benefits. This is important in a country where the rating agency Fitch has described debt levels as "unsustainable."

One of the complications of using interest rates to stimulate an economy is that it encourages people to borrow, leaving an overhang of high-cost debt when interest rates inevitably rise again. Low rates also drive up asset prices, including the price of houses and stocks, disproportionately benefiting the owners of capital and increasing the rich-poor divide.   

Cheap oil may not last forever, but for now it gives a fillip to everyone, rich or poor, who drives or heats their home. It lowers the cost of almost everything that is transported long distances, which in a globalized economy is almost everything.

"Lower oil prices will also benefit many sectors, such as manufacturing, by reducing production costs," Timothy Lane, the Bank of Canada's deputy governor, said last week

Straight to the wallet

The other advantage is that the benefit of lower-priced oil goes straight into the pockets of consumers rather than passing through the hands of bankers who rake off their cut in the lending process and who direct loans, quite reasonably, to those most likely to pay the money back. That may not be the people or businesses that need the money most.

The most important difference is that unlike a cut in rates, a crash in the price of oil smashes the most dynamic part of the Canadian economy — the oil extraction and exploration sectors. Interestingly, though, the processing sectors of the energy business will also benefit from lower oil. Demand for oil products will rise as prices fall while the cost of feed stock and transportation declines.

But Poloz has decided that this is small comfort for the integrated petroleum industry and the governments that depend on it for tax and royalty revenue. For the oil-producing provinces, their governments and others that derive their political power there, interest rate cuts are just what the doctor ordered.

Good or bad?

There has been much debate in business headlines over whether falling oil is good or bad for the economy. In fact, it is both. Perhaps the greatest difficulty for Poloz is that while the damaging effect of the oil crash is hitting now, the benefits may not come for as long as a year.

That delayed response is another similarity between rate cuts and the stimulus of lower oil prices. Businesses do not appear overnight. Export growth and increases in consumer confidence are not instant. The process of how rate cuts work their way through the economy is complicated. But if falling oil prices have a similar effect, it is likely the economy won't really kick into gear until at least the end of 2015.

"The maximum effect of a change in interest rates on output is estimated to take up to about one year, and the maximum impact on consumer price inflation takes up to about two years," says the Bank of England report How Monetary Policy Works

This demonstrates the potential danger now that Poloz has felt the pressure to cut rates and boost areas like Saskatchewan, Alberta, and Newfoundland and Labrador, which are already hurting. The stimulative effects of a rate cut and the oil price decline could well hit at the same time, sending the economy into overdrive in B.C. and the industrial East, and forcing him into a subsequent painful increase in rates.

While the falling price of oil may give some parts of the economy a pick-me-up, that, combined with a rate cut, may turn out to be too much of a good thing.

About the Author

Don Pittis

Business columnist

Don Pittis was a forest firefighter, and a ranger in Canada's High Arctic islands. After moving into journalism, he was principal business reporter for Radio Television Hong Kong before the handover to China. He has produced and reported for the CBC in Saskatchewan and Toronto and the BBC in London. He is currently senior producer at CBC's business unit.

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