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Sunday, February 1, 2009

Weekly Market Insight


Governments and central banks continue to fire from all directions. In the US, the fed funds rate is already at
zero. But the Fed continues to ease in different ways. Mr. Bernanke is now targeting not the fed funds rate but
rather private sector borrowing rates. By buying spread products, the Fed is trying to lower borrowing cost and
stimulate borrowing activity. Bank loans and leases outstanding increased by $8 billion in the latest week, the
first rise in four weeks, but are up just 1% from this time last year.

The Bank of Canada’s 50 basis points rate cut this week was not the last one for this cycle. Look for the Bank
to cut by another 50 basis points come March. This move is already fully discounted by the market and will not
have any significant impact on long-term rates.

But even if the Fed and the Bank of Canada are successful in lowering borrowing rates, you still need to create
conditions in which households will be willing to borrow. We know that there is some pent up demand for
borrowing following the recent decline in US long-term mortgage rates (after the Fed actively purchased MBA
securities), refinancing activity has tripled. But in order to insure a sustained rise in credit demand, we need a
stronger level of economic activity, and that’s where governments enter the picture.

In the US, the Obama Administration will soon introduce an estimated $875 billion in fiscal stimulus and in
Canada, we will see roughly $30 billion of new spending this year. A notable portion of this spending will go
towards infrastructure. And from an economic perspective, this is important as the economic multiplier of
infrastructure spending is significant. After all, when it comes to creating jobs and stimulating activity,
infrastructure spending is a much more effective tool than tax cuts. In the US, the impact of economic growth
of infrastructure spending worth 1% of GDP is more than double the impact of tax cuts, which have a greater
leakage to imported consumer goods, and which risk being saved by households. In Canada, $10 billion of
infrastructure spending can potentially create 110,000 jobs and lift economic growth by close to 1.5
percentage points—well above the stimulus effect of a tax cut of a similar size.

And that’s the main reason for the renewed optimism by the Bank of Canada, which now calls for a continual
recession in the coming six months but a healthy recovery in the second half. This is more or less in line with
our ongoing view—the combination of monetary and fiscal stimulus will be powerful enough to turn things
around in the second half of the year.

Benjamin Tal
Senior Economist
Economics & Strategy

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