The Bank of Canada confounded most economists by cutting its target rate for overnight funds by 25 basis points to 3% Tuesday.

The operating band for the overnight rate was correspondingly lowered, and the Bank Rate now sits at 3.25%.

The bank says recent months have brought a number of unanticipated developments that bear on the outlook for inflation and economic activity in Canada. In the short term, says the bank, domestic economic activity has been undercut by the effects of SARS and the single case of mad cow disease in Alberta.

While most were taken off guard, economists applauded the central bank’s move, and suggest rates could go lower yet.

“The Bank of Canada’s decision this morning may have come as a surprise to financial markets — which had completely priced out any action on the rate front — but ultimately, the central bank threw the optics out the window, and came down with the right decision,” applauds TD Bank. “The combination of sub-par economic growth, mounting excess slack, and a notable lack of any upward pressure on inflation provides the Bank of Canada with all the room it needs to take out additional insurance against further economic weakness – and visibly, it wasted no time in seizing the opportunity.”

Bank of Montreal admits that it was caught by surprise, “though the move seemed warranted given the dramatic change in economic conditions since the Bank last raised rates in the spring.”

BMO says that the rate cut was motivated by several factors, “a faster-than-expected decline in inflation and inflation expectations, the negative impact on domestic demand of SARS and an isolated case of mad-cow disease, continued soft foreign demand, and, most importantly, the ‘rapid and sizeable’ appreciation of the Canadian dollar. The latter has resulted in a significant tightening in monetary conditions since the start of the year.”

“David Dodge is willing to admit his mistakes, and that’s welcome news for a Canadian economy that needs a dose of stimulus,” says CIBC World Markets. “While we had forecast two rate cuts before year end, we didn’t give Dodge enough credit for being flexible in response to an economic train that has come off the rails.” CIBC says that this rate cut is “as well justified as the last two rate hikes were not”.

RBC Financial says that, despite the near-term concerns about the economy, the Bank of Canada still expects growth to strengthen towards the end of 2003 and through 2004, underpinned by domestic demand and an expected rebound in the U.S. “As such, the Bank seems to have adopted a neutral bias going forward. Therefore, we do not see this as the first of several easing moves and we expect the 3% overnight rate to be maintained through the third quarter of next year. Given that the Fed is holding its rate at 1%, a steady overnight rate spread at 200 basis points will continue to be a supportive factor for the Canadian dollar,” RBC says.

BMO also expects rates to remain stable for the remainder of the year, provided that the upcoming economic data support the Bank’s outlook, “However, the risk of another reduction at the September 3 scheduled announcement date remains significant should the data disappoint,” it allows.

CIBC says that the rate cut gives a bit of lift to interest sensitive sectors of the economy, “but the direction for rates on longer-term mortgages and corporate bonds will be much more tied to what Alan Greenspan does, or doesn’t do, about rising US bond yields.” It is looking for a further quarter point cut by the Bank in September as growth disappoints in Q3.

The Bank’s next scheduled date for announcing the overnight rate target is September 3.

TD says another 25 bps rate cut in September remains a good bet. “With the full impact of the currency’s appreciation spilling through to Canada’s export sector, the Bank is likely to take out an additional round of insurance. However, by no means is the outcome a slam-dunk. Should the U.S. economy power ahead in the second half of the year — which does not seem likely at this stage — the Bank could decide to stay its hand. In any event, stay tuned for Thursday’s Monetary Policy Report Update for a more complete picture of the Bank’s view of the world.”