OTTAWA (Reuters) - The Bank of Canada stunned markets by cutting interest rates on Wednesday, citing a threat to economic growth and its inflation targets from the dramatic drop in oil prices and said the bank stood ready to ease policy further if necessary.
Governor Stephen Poloz said the central bank's surprise move to stimulate the economy provides "insurance" against risks for Canada, a major oil producer, stemming from the "oil price shock".
He said oil's plunge could worsen household debt burdens by driving up unemployment and cutting incomes.
"We must remember that the world changes fast and if it changes again, we have the ability to take out more insurance or on the reverse, to reduce how much insurance we've taken out," Mr Poloz told reporters.
The bank cut its overnight benchmark to 0.75 per cent from 1 per cent, where it had been since September 2010, ending the longest period of unchanged rates in Canada since 1950.
The cut caught markets by surprise and sent the Canadian dollar to a nearly six-year low against the greenback. The Toronto stock market's main index surged 1.8 per cent.
"We didn't think things had deteriorated enough for the Bank of Canada to move as quickly as this," said Mr Adam Cole, head of G10 FX strategy at RBC in London.
Mr Poloz pointed out the bank had been talking publicly about the economic costs of cheaper oil.
"All the ingredients for the rate decision were out in the open. And I thought people were pretty close to it," he said.
Oil prices have fallen by half in the past six months to below US$50 a barrel, and Canada is the biggest foreign supplier of crude oil to the US market.
While cheaper energy will broadly help the United States and other importers, it will be"unambiguously negative" for Canada, the bank said.
The bank slashed its economic growth estimate for the first half of 2015 to 1.5 per cent from 2.4 per cent, meaning excess capacity in the economy will increase rather than being mopped up.
It estimated cheaper oil will shave 0.75 percentage point off what Canada's growth would have been during the year, after weighing mitigating factors.
The bank said, however, that growth should pick up to 2.4 per cent next year from 2.1 per cent for full-year 2015.
Cheap oil will have a dramatic effect on overall inflation, which the bank said would be below its target range of 1 to 3 per cent for most of 2015 and as low as 0.3 per cent in the second quarter.
"Clearly the bank is more worried about the economy and missing its inflation target than it is about household financial imbalances and the overvaluation in some housing markets," said Mr Sal Guatieri, senior economist at BMO Capital Marketsin Toronto.
The bank acknowledged oil prices below forecast could turn inflation briefly negative, but Mr Poloz made clear he did not consider that to be deflation in the full sense of the term since it would not reflect a broad price fall.