Canada's Bipolar Economy

July 22, 2008

Officials at the Bank of Canada project Canadian GDP growth of just 1.5% in the second half of 2008, which compares to theoretical trend growth in the period of 2.8% if productive resources were to be fully utilized.  They anticipate drags from net foreign demand of 1.9 percentage points in full-2008 and 1.1 ppts in full-2009 and look for continuing and identically low 1.5% GDP growth during 2009 in the United States, Euroland and Japan.  Shifts in net exports, which are seen shaving just a tenth of a percentage point (ppt) from growth in 2010, account for variation in Canada’s business cycle, along with a better inventory picture after 2008.  Final domestic demand is expected to make a positive and solid contribution to GDP growth of 3.4 ppts in 2008, 2009, and 2010.  A semi-annual forecast released in April had assumed oil prices would average $109 in 2H08, $105 in 2009 and $102 in 2010.  Such has now been revised to $141, $142, and $141, which are based on futures prices.  But those revisions released last week already are some distance above actual levels.  The central bank in Canada faces a common inflation forecasting problem.  Nobody really knows what oil prices will do.  Recent experience is that such prices swing wildly and dominate overall CPI figures.  Monetary policy today needs to address expected inflation down the road, but oil price volatility weakens the ability to anticipate what inflation will be at different interest rate settings.  The revisions in assumed oil costs caused projected total CPI inflation in the second half of 2008 to get bumped up to 3.95% from a forecast of 1.9% made just three months ago.  Officials expect total CPI inflation to peak at 4.3% in 1Q09, which is 130 basis points above the central bank rate target. 

Several recent Canadian economic indicators surprised on the upside.  Wholesale trade jumped 1.6% in May and rose by 0.7% in volume terms.  May exports jumped 5.4%, and manufacturing sales and orders climbed in May by 2.7% each.  Compared to their levels at end-2007, sales were up 5.5%, and orders had risen 3.8%.  Net capital inflows generated by Canadian transactions in securities with foreigners increased sharply to C$ 4.2 billion per month in April-May from C$ 2.14 billion per month in the first quarter of 2008.  All this does not detract from the fact that Canadian growth in 2008 is apt to be lower than in any year since 1992.  GDP slid 0.3% in 1Q, and the annualized expansion of employment slowed to 0.7% over the last four reported months.  May retail sales get reported in Canada later today, followed by consumer prices tomorrow.  The Canadian dollar has not performed as well as the Australian dollar, a fellow commodity-sensitive currency.  Conventional wisdom attributes that discrepancy to Canada’s close ties to the United States, whose economy continues to teeter on the brink of recession.  The Australian central bank rate target, 7.25%, is moreover 425 basis points above the Bank of Canada overnight money target of 3.0%.

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