The Bank of Canada cut the overnight rate by 25 basis points to 2.25% on growing concerns about the downside risks to the outlook for Canada's economy. The Bank explicitly stated a bias to reduce the policy rate even more, saying that "some further monetary policy stimulus will likely be required" to keep inflation on target and highlighted that risks to the outlook, both upside and downside, remain "significant."

With credit conditions tightening, the U.S. economy in recession and commodity prices coming off the boil, the Bank downgraded the forecast for Canadian economic growth to 0.6% in both 2008 and 2009. This was a decisive cut to their July forecast of 1.0% in 2008 and 2.3% next year. The forecast for 2010 was inched up to 3.4% from 3.3% in the July projection. The weaker growth profile and lower energy prices will result in inflation pressures easing "significantly" compared to their previous forecast, the Bank said.

The Bank highlighted three developments that are negatively affecting the outlook for Canada's economy - the "intensification of the global financial crisis," signs that the global economy is heading into recession and the weakening in commodity prices. These conditions will weigh on all parts of Canada's economy with the Bank expecting an increased drag from exports and more moderate domestic demand growth. The domestic economy has been the mainstay of Canada's economic growth performance, but the deterioration in the terms of trade due to the weakening in commodity prices and the tightening in credit conditions mean that the Bank expects overall "growth to be sluggish through the first quarter of next year."

While the Bank forecasts weak growth in the near-term, it offered a slightly more upbeat assessment over the medium-term, with the economy forecast to pick up pace "over the rest of 2009 and to accelerate to above-potential growth in 2010" as easy monetary policy, improving credit conditions and a resumption of stronger global growth support activity. The Bank also pointed to the weakening in the Canadian dollar as providing support to economy.

On inflation, the Bank forecasts that the all-items rate peaked in the third quarter and will fall below 1% in mid-2009 with the core rate expected to remain below 2% until the end of 2010.

Although the Bank decided to move in a smaller step than we expected today, with the U.S. economy in recession and other global trading partners slowing, the Bank indicated that some additional easing may be necessary and we expect that it will cut the policy rate to 2% before year-end to shore up Canada's domestic economy as the boost from the terms of trade weakens.

The Bank will provide a more complete update on their outlook for the Canadian economy in the October Monetary Policy Report to be released on Thursday.