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Financial Markets

Interest Rates

After following a slight tightening trend through 2007, the US Federal Reserve Board cut its key overnight target rate by 75 basis points to 3.50 per cent on January 22, 2008, in response to mounting fears of a recession and associated rapid weakness observed in stock markets worldwide. The cut was not scheduled, but viewed as necessary to mitigate increasing downside risks to growth in the economy and a deepening of the housing contraction. It marked the single biggest rate cut by the Fed since 1982.

The Fed cut its key rate a further 50 basis points in its scheduled announcement on January 30, 2008, in a further effort to aid the suffering US economy. The Fed funds rate, now sitting at 3.00 per cent, is at its lowest since June 2005. In their January 30, 2008 statement, the Fed stated that risks remain to the downside and that it plans on acting in a timely manner as needed to address those risks.

On January 22, 2008, the Bank of Canada (BoC) lowered its key interest rate (the target for the overnight rate) by 25 basis points to 4.00 per cent, as widely anticipated. The BoC noted that while the Canadian economy continues to operate above capacity right now, the US economy is suffering a more prolonged housing decline than previously expected. This will lead to downward pressure on Canadian export growth and lower inflation. The statement concluded that further stimulus will likely be necessary moving forward to keep aggregate supply and demand in balance, and to return the inflation rate to the BoC’s target over the medium-term.

Outlook

Based on the average of six private sector forecasts as of January 9, 2008, the Ministry of Finance interest rate outlook assumed that the US Federal Reserve would begin lowering interest rates at their January 30, 2008 meeting. With the unscheduled cut announced on January 22, 2008 however, the Fed’s target rate will be lower throughout the year compared to private sector forecasters’ views as of January 9, 2008. The private sector anticipated the Fed funds rate would average 3.8 per cent in 2008 and 4.1 per cent in 2009.

As of January 9, 2008, the private sector forecast assumed that the Bank of Canada would lower the overnight target rate by 25 basis points in their January 22, 2008 meeting (which did occur) then raise the rate by 25 basis points in December 2008. The Bank was then expected to raise it by a further 25 basis points in early 2009 and then hold it steady at 4.50 per cent for the rest of the year.

The average of private sector forecasters’ views on Canadian short-term interest rates (3 month treasury bills) as of January 9, 2008 (see Table 4.3) indicates that 90 day rates will average 3.9 per cent in 2008 and 4.4 per cent in 2009.

Table 4.3.

Ten-year Government of Canada bonds are forecast to average 4.2 per cent in 2008 and 4.8 per cent in 2009, indicating that the spreads between long-run and short-run rates are expected to remain positive.

Table 4.4.

Exchange Rate

The Canadian dollar continued its trend of appreciation against the US dollar in 2007, due in part to a general weakening of the US dollar and high prices for commodities such as oil and metals. The noon spot rate peaked at 109.1 US cents on November 7, 2007 then drifted back down to parity a couple of weeks later, and has remained within a few cents of parity ever since. For the year, the dollar averaged 93.5 US cents, appreciating 5.3 cents over the 88.2 cents average in 2006.

Chart 4.6.

Outlook

The Canadian dollar is expected to retain its strength in the near-term, due to high commodity prices and weakness in the US dollar. The loonie is expected to drift down slightly vis-à-vis the US dollar in the medium-term as the US dollar recovers from its current weakness.

Average private sector forecasts as of January 9, 2008 expect the Canadian dollar will average 99.9 US cents in 2008, falling to 96.1 US cents in 2009. The Ministry of Finance’s exchange rate outlook is based on these private sector averages (see Table 4.5). The Ministry of Finance assumes that the Canadian dollar will fall to 93.3 US cents by 2012.

Table 4.5.

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