Bank of Canada in unfamiliar policy waters
The Bank of Canada will be sailing into uncharted waters this week, when it is expected to hold interest rates at a historic low of 0.5 per cent but will unveil a list of possible other steps it could take to stimulate the slumping economy.

Here are the key factors weighing on the bank’s decisions:

Recession: Carney must decide whether the lagged effects of past rate cuts and fiscal stimulus are enough to turn the economy around as expected in the second half, or if more monetary stimulus is needed.

The country is on track to post one of the worst economic performances in its history in the f irst quarter. But government and central bank policy-makers have said a recovery will likely arrive sooner in Canada sooner than in other major economies.

Carney took a lot of heat from market players and politicians for the bank’s January forecast of 3.8 per cent growth next year and has since backed away from that view.

Analysts surveyed by Reuters expect a 6.1 per cent firstquarter contraction, followed by a 2.1 per cent decline in the second quarter, and a return to growth in the second half.

Inflation: Inflation is low, but there is no tangible threat of a prolonged deflationary period at this point.

The bank adjusts rates to keep inflation at about two per cent over the medium term, and within a range of one to three per cent.

Fi r s t - q u a r t e r inflation came in roughly in line with the bank’s expectations at 1.2 per cent, but economists and senior business managers predict a much weaker rate and possibly falling prices in the remainder of this year as the full effects of the recession are felt.
In its January outlook, the bank saw year-on-year consumer prices falling in the second and third quarters before climbing again.

Over t hree-quarters of senior business managers surveyed by the bank saw inflation staying below two per cent over the next two years, while 41 per cent saw it below one per cent in that same period.

Credit markets: Both Carney and Finance Minister Jim Flaherty said this month they had seen small signs of improvement in some segments of the credit market even though spreads remain higher than the historical average.

Some of the bank’s auctions to boost liquidity in shortterm markets have gone unsubscribed, and demand has dwindled for government purchases of mortgages — suggesting funding conditions have improved.

Loan officers surveyed by the central bank said credit continued to tighten in the first quarter but that view was less widespread than in the fourth quarter.

Central bank rate cuts have been largely transmitted to the broader economy through lower prime lending rates by major commercial banks.

Technical considerations: If the bank cuts its overnight rate to 0.25 per cent, it may have to alter its operating band to avoid distortions in the money market.

The operating band sets the rate paid on deposits with the Bank of Canada (the deposit rate) at 25 basis points below the overnight rate and the rate charged on borrowing funds from the bank (the bank rate) at 25 basis points above the overnight rate.

If the benchmark overnight rate is reduced to 0.25 per cent the deposit rate would have to be zero. This could remove incentives for lending because, after taking into account transaction costs, effective market rates would be negative.

Instead, the bank could make the overnight rate become the lower limit