Bank of Canada cuts rates again as oil's dive stalls economy

By Randall Palmer and Leah Schnurr

OTTAWA (Reuters) - The Bank of Canada cut its benchmark interest rate for the second time this year on Wednesday to combat a shrinking economy, a move that drove the Canadian dollar to a six-year low.

Bank Governor Stephen Poloz had expected a recovery by now from the oil price crash that hit Canada's oil-exporting economy in the first quarter, but that projection has proved far too optimistic.

"The facts have changed, quite quickly actually, in the last two to three months," Poloz told reporters. "One of the big shocks in this outlook is the downgrade of investment intentions by the companies in the oil patch."

The 25-basis-point rate cut, which lowered the bank's benchmark rate to 0.5 percent, came the same day as U.S. Federal Reserve Chair Janet Yellen said the Fed was on track to raise rates this year. The diverging outlooks helped Canadian bonds outperform U.S. Treasuries, while the country's main stock market index jumped and the Canadian dollar sank.

Canada's central bank now expects the economy to have shrunk by an annualized 0.5 percent in the second quarter instead of growing by the 1.8 percent that Poloz had projected in April. It contracted 0.6 percent in the first quarter. Two quarters of contraction are commonly defined as a recession.

The market had been split on whether the bank would cut again. The bank had delivered a surprise 25-basis-point cut in January that was designed to counter the dive in oil prices.

The Canadian dollar tumbled to its weakest level against its U.S. counterpart - C$1.2958, or 77.17 U.S. cents - since March 2009, during the financial crisis.

"The currency is in uncharted waters here," said Derek Holt, vice president of economics at Bank of Nova Scotia, citing a risk that the Canadian dollar would weaken to as low as C$1.30 against the greenback, then dive to C$1.40.

"If the Fed is hiking, we think by September, and the Bank of Canada appears to be leaving the door open to additional rate stimulus, all bets are off."

The bank said excess capacity in the economy grew significantly in the first half and would continue to do so in the third quarter, even with expected economic growth of 1.5 percent.

It therefore pushed back to the first half of 2017 its projection of when full capacity will be reached and inflation return to the bank's 2 percent target. Its previous projection had been for the end of 2016.

The bank acknowledged elevated risks from a hot housing market in Toronto and Vancouver and rising household debt, factors that had prompted some economists to advise against a rate cut.

Poloz said the central bank had weighed the risk that a rate cut will increase financial imbalances, but decided its "primary mission" was to address struggling growth.

"The best contribution that we can make to getting things back to a more normal setting is to address the shock that the economy is going through," he said.

He also said the bank has additional room to maneuver if forecasts disappoint.

The bank continues to see a soft landing in housing.

Perhaps the biggest disappointment for Poloz, former head of the federal export agency, has been what the bank said was a "puzzling" weakness in non-energy exports. He had hoped such exports would help offset the negative effects of lower oil prices on business investment and incomes.

But the bank said its base-case projection assumes "that this unexplained weakness is temporary and that the relationship between exports and foreign activity will reassert itself."

(Additional reporting by Alastair Sharp, Solarina Ho and Andrea Hopkins in Toronto and Allison Lampert in Ottawa; Editing by Peter Galloway and Jeffrey Hodgson)