by John Shmuel,

Published on January 21, 2015

The Bank of Canada surprised markets Wednesday with a 25 basis point cut to its benchmark interest rate. It marks the first time since September 2010 that the bank has moved on rates, though the move was completely unexpected.

Governor Stephen Poloz called the cut “insurance” against low oil prices and their harm to the Canadian economy. Below are five key takeaway messages from the rate cut, which brings the benchmark rate from 1% to 0.75%.

Oil price uncertainty

The bank made it clear right off the bat that its cut was due to the collapse in oil prices, which it expects will do notable harm to Canada’s economy this year.

“Business investment in the energy-producing sector will decline,” the bank said in a statement. “Canada’s weaker terms of trade will have an adverse impact on incomes and wealth, reducing domestic demand growth.”

The bank’s current base-case projection sees oil prices averaging about US$60 per barrel this year, compared with current prices of about US$46 a barrel.

“Prices are currently lower but our belief is that prices over the medium term are likely to be higher,” the bank said.

Lower inflation

One of the biggest impacts of low oil prices will be on inflation. The bank now sees inflation missing its 2% target this year.

“Total CPI inflation is projected to be temporarily below the inflation-control range during 2015, moving back up to target the following year,” the bank said. “Underlying inflation will ease in the near term but then return gradually to 2 per cent over the projection horizon.”

Output gap to close later

The bank has once again pushed back when it projects the Canadian economy will return to full capacity. The difference between that and the current level, or the output gap, is projected to widen this year.

“Although there is considerable uncertainty around the outlook, the Bank is projecting real GDP growth will slow to about 1 1/2 per cent and the output gap to widen in the first half of 2015,” the bank said.

It predicts, however, that some harm from lower oil prices will be mitigated by a stronger U.S. economy, a weaker Canadian dollar, and the bank’s rate cut.

“The economy is expected to return to full capacity around the end of 2016, a little later than was expected in October,” the bank said.

New financial risks

For the first time since the oil price collapse, the bank said that low oil prices pose a risk to Canada’s banks.

“The oil price shock increases both downside risks to the inflation profile and financial stability risks,” the bank said. “The Bank’s policy action is intended to provide insurance against these risks, support the sectoral adjustment needed to strengthen investment and growth, and bring the Canadian economy back to full capacity and inflation to target within the projection horizon.”

Weak Canadian economy

The bank cut its growth outlook for 2015 to 2.1%, from its earlier call of 2.4%. It expects the first quarter of this year to be particularly weak for Canada, saying growth will amount to just 1.5%.

But the bank notes that beyond the energy sector, there are signs of growth in the Canadian economy.

“The oil price shock is occurring against a backdrop of solid and more broadly-based growth in Canada in recent quarters,” the bank said. “Outside the energy sector, we are beginning to see the anticipated sequence of increased foreign demand, stronger exports, improved business confidence and investment, and employment growth.”

Still, expectations of when the economy will return to full capacity have been pushed back to the end of 2016.