The Bank of Canada will cut rates by a further 50 basis points next week, with the U.S. central bank following suit soon after, RBC Economics says.

“The combination of a deteriorating outlook for the US economy, falling commodity prices and persistent financial market volatility are boosting the downside risks to Canada’s economic outlook and will likely see the Bank of Canada lower the policy rate by 50 basis points at next week’s meeting,” RC says in a research note.

“Despite a concerted effort by global central banks and governments to ease market concerns about counterparty risk and shore up investor confidence, financial markets continue to flail with equity markets unable to sustain gains. Wholesale funding costs have started to ease but remain elevated meaning that the cost of capital for businesses and households is staying high and availability limited,” it reports. The Bank last cut rates on October 8 in a coordinated move with several other central banks. RBC says that “Given the steady decline in commodity prices since October 8, inability of equity markets to sustain an improved tone and increasingly weak U.S. data reports, we think it is likely that the Bank will choose to act aggressively next week and cut the policy rate to 2%.”

RBC also expects the U.S. Federal Reserve Board to lower its rates by another 50 bps before the year’s out with the odds favouring the move at the October 29 meeting. “Economic data have been weaker-than-expected and risk a sharper downturn in Q3 and Q4 than in our baseline forecast. More worrying is the lack of traction in financial markets from the spate of policy actions with equity markets still preparing for the worst while the 3-month Libor rate is lower but remains relatively elevated. Yesterday’s Beige Book provided no sign that any region of the US economy is seeing an improvement in conditions,” the firm says.

“While we believe the aggressive policy actions will eventually boost investor and consumer confidence and allay uncertainty in financial markets thereby reducing the cost of funds for financial institutions and ultimately credit spreads, the Fed will continue to keep the financial system flush with cash and interest rates extremely accommodative until a decisive turn is evident. This is unlikely to occur quickly and we maintain the view that the economy will only start to revive in late 2009,” it adds.

RBC’s view is that the 1% funds rate plus narrowing credit spreads will be sufficient to avoid a protracted economic recession “although given the depth of the negative sentiment, we cannot rule out additional interest rate cuts,” it allows. “We expect the Fed to hold the policy rate at 1% throughout 2009 and forecast only a modest increase in term rates over the year ahead. This is a change from our previous forecast that the Fed would be in a position to increase the policy rate before the end of next year.” In Canada, if the Bank doesn’t cut rates, or only cuts by 25 bps next week, RBC expects a cut at the December meeting meaning that the overnight rate would still end 2008 at 2%.

“Our assessment remains that growth in Canada will be stronger than the US in 2009 although the pace will be slower than the economy’s potential,” it adds. “Our view that the significant tightening in credit conditions will begin to ease in the months ahead will go some distance to shoring up consumer and business confidence and prevent the economy from slipping into a recession. However, the risk that spreads remain wide and lending standards tight cannot be discounted and supports the case for the Bank to move aggressively in the near term and then hold the policy rate at 2% for several quarters.”

As it expects the economy to return to a firmer growth path in the second half of 2009, RBC believes that the Bank will be in a position to raise the overnight rate to 2.25%.