Interest rate cut doubles effect of falling oil price: Don Pittis

(Editor's Note: this column has been updated to incorporate Wednesday's interestrate cut, but its message remains essentially the same.)

The Canadian dollar has beenfalling. Inflation is down to the point where manycountries are worried insteadabout deflation. The economy has beengetting a boost as the cost of doing business and the cost of living bothfell.

Normally we'd associate all these things with a cut in interest rates. Low inflation opens the door to cuts. But until today the cause has been falling oil prices. Now the Bank of Canada governor StephenPolozhas doubled down on the stimulative effect with a surprise cut in rates.

Once it kicks in, thisdouble stimulation should perk up the Canadian economy. But like drinking beer with shots, it may also double the hangover.

• Polozshocks market with cut to key interest rates
• Oil and deflation

In some ways andin some parts of the countryfalling oil prices are a big improvement onrate cuts, chief of which is that lower oil does not force peopleor businessesto borrow more money to getthe benefits. This is important in acountry where the rating agency Fitch has described debt levels as "unsustainable."

• 'The market is worried'Looniedrops to near six-year low
• Canadians' debt levels 'unsustainable' says Fitch

One of the complications of using interest rates to stimulate an economyis that itencouragespeople to borrow, leaving an overhang of high-cost debt when interest rates inevitably rise again.Low rates also drive up asset prices, includingthe price of houses and stocks,disproportionately benefiting the owners of capital and increasing the rich-poor divide.

Cheap oil may not last forever, but for now it gives a fillip to everyone, rich or poor, who drives or heats their home. It lowers the cost of almost everything that is transported long distances, which in a globalized economyis almost everything.

"Lower oil prices will also benefit many sectors, such as manufacturing, by reducing production costs," Timothy Lane, the Bank of Canada's deputy governor,saidlast week.

Straight to the wallet

The other advantage is that the benefit of lower-priced oil goes straight into the pockets of consumers rather than passing through the hands of bankers who rake off their cut in the lending process and who direct loans, quite reasonably, to those most likely to pay the money back. That may not be the people or businesses that need the money most.

• Poloz awaits sunrise after Canada's long industrial sunset

The most important difference is that unlike a cut inrates, a crash in the price of oil smashes the most dynamic part of the Canadian economythe oil extraction and exploration sectors. Interestingly, though,the processing sectors of the energy business will also benefit from lower oil. Demand for oil productswill rise as prices fall whilethe cost of feed stockand transportation declines.

But Poloz has decided that this is small comfort for the integrated petroleum industryand the governmentsthat depend on it for tax androyalty revenue.For theoil-producing provinces, their governments and others that derive their political power there, interest rate cuts are just what the doctor ordered.

Good or bad?

There has been much debate in business headlines overwhether falling oil is good orbad for the economy. In fact, it is both. Perhaps the greatest difficulty for Polozis that while the damaging effect of the oil crash is hitting now, the benefits may not come for as long as a year.

That delayed response is another similarity between rate cuts and the stimulus of lower oil prices. Businesses do not appear overnight. Export growth and increases in consumer confidence are not instant. The process of how rate cuts work their way through the economy is complicated. But if falling oil prices have a similar effect, it is likely the economy won't really kick into gear until at least the end of 2015.

"The maximum effect of a change in interest rates on output is estimated to take up to about one year, and the maximum impact on consumer price inflation takes up to about two years," says the Bank of England reportHow Monetary Policy Works.

This demonstrates the potentialdanger now thatPolozhas felt the pressure to cut rates and boost areas like Saskatchewan, Alberta, and Newfoundland and Labrador, which are already hurting. The stimulative effects of a rate cut and the oil price decline could well hit at the same time, sending the economy into overdrive in B.C. and the industrial East, and forcing him into a subsequent painful increase in rates.

While the falling price of oil may give some parts of the economy a pick-me-up, that,combined with a rate cut, may turn out to betoo much of a good thing.