Canada: Slower Growth in 2008

Summary and conclusions

After four years of strong growth, I expect the Canadian economy to decelerate in 2008. The anticipated recession in the US is likely to be the main drag to growth, while domestic demand should moderate somewhat. Growth should rebound in the second half of the year. Overall, I forecast growth to average 1.7% in 2008 while core inflation should decline as a result of past currency appreciations and the slowing economy. In response to moderating growth and inflation, I expect the Bank of Canada to cut interest rates by 100bp by mid-year, bringing the interest rate to 3.25%, and remain on hold thereafter.

Economic growth

The Canadian economy has enjoyed strong growth of close to 3% on average over the past few years. This enviable performance is the result of sound macroeconomic policies, structural reforms and favourable external conditions. As a result of the solid growth, the Canadian economy is operating beyond its capacity, according to the Bank of Canada. Over recent years, the strong labour market has boosted disposable income in Canada, and this has translated into strong household spending. In addition, the terms of trade improvement coming from higher commodity prices has led to higher real income and stronger domestic demand. However, vigorous domestic demand coupled with a stronger currency translated into solid imports, while the currency appreciation and sluggish demand from the US slowed export growth, resulting in a drag on the economy from net exports.

Going forward, I expect the drag coming from net exports to intensify. First, the sharp currency appreciation over 2007 should continue to have a negative impact on exports, while providing some support to imports. Second, our US economic team expects a recession in 1H07. Growth in the US is now expected to be negative in the first two quarters of the year before rebounding in the second half, for a growth rate of 1.1% for 2008 as a whole.

In addition, I expect domestic demand to moderate in 2008 from its current high level. Tighter credit conditions are likely to put some pressure on the Canadian economy, but the impact should be less than in the US. Consumer spending should abate somewhat, as the labour and the housing markets soften, while the one percentage point cut in the GST could prove to be not so supportive. Investment in machinery and equipment should also moderate, as slowing demand from the US is likely to mitigate the impact from lower costs for imported equipment coming from a stronger Canadian dollar and high corporate profits. In addition, weaker commodity prices will likely offset some terms of trade gains made in 2007, reducing their impact on real incomes and domestic demand.

In 2H08, I assume that the rebound of the US economy will provide some support to Canadian exports. This should reduce the drag on the economy coming from net exports and lead to a reacceleration of the Canadian economy.

Overall, I expect growth in Canada to slow in 1H08 to a rate of around 1.0% before rebounding in 2H, with growth at around 2.0%. On average, growth in 2008 is forecasted at around 1.7%.

Inflation profile

Inflation has remained higher than the Bank of Canada’s 2% target and its expectations in 2007: inflation is likely to have averaged 2.3% for headline and 2.5% for core.

With the forecasted slowdown of the Canadian economy, I expect excess demand pressures to gradually dissipate and to reverse to a small excess supply. In addition, the past appreciation of the Canadian dollar should continue to push prices of imported goods lower, while the moderation in house price inflation should reduce the upward impact coming from the housing component. In addition, a slight base effect is likely to also contribute to bringing core inflation lower. As inflationary pressures abate, I expect core inflation to gradually drift lower throughout 2008, from 2.0% at the end of 2007 to reach 1.5% by mid-year and a low of 1.3% by the end of the year – well below the Bank of Canada’s target for inflation.

Headline inflation should be distorted for most of the year by the one percentage point cut in the GST. Past estimates from the Bank of Canada point to a 0.6 percentage point drop in headline inflation as a result of lower sales tax . Once this effect is removed, headline inflation should start the year high due to strong oil prices, before creeping lower as commodity prices abate.

Monetary policy

The Bank of Canada pre-emptively cut interest rates by 25bp in early December, as the combined impact of the sharp CAD appreciation, tighter credit market conditions and weaker US growth outlook will likely slow the Canadian economy in 2008.

Since December, credit markets in Canada have improved somewhat. As the Bank of Canada pointed out on January 4 2007, “pressures in short-term money markets have eased from their earlier peaks, although spreads have not yet returned to historical levels”. The spread between the overnight rate and 3-month Libor, the 3-month corporate paper, and the 3-month banker acceptances have decreased, but are still higher than their 10-year averages. Some market participants are debating whether we have experienced a fundamental repricing of risk.

Against the backdrop of improving financial markets conditions, a slowing Canadian economy and decreasing inflationary pressures, I think that the Bank of Canada will remain pre-emptive and continue to cut interest rates sooner rather than later. We are now in a period where the cost in terms of inflation from cutting interest rates is outweighed by the cost in terms of growth coming from leaving interest rates on hold for too long. In addition, inflation expectations in Canada remain well anchored close to the BoC’s target. I therefore expect the Bank of Canada to cut rates by 50bp in 1Q – 25bp at the January meeting and a further cut at the March meeting – and then twice again in 2Q, bringing overnight rates to 3.25% by mid-year. I then expect interest rates to remain on hold for the rest of the year. However, there is always the risk that the Bank of Canada could move by 50bp if it judges it necessary to front-load some of the cuts.

Risks

There is some risk that growth could surprise on the upside. I have advocated in the past that, during the last five years, the links between the US and Canada have weakened somewhat and that growth in Canada is less dependent on exports than during the previous recession. Therefore, Canada could be less negatively affected by a US recession than in the past. In addition, the solid gains in household income in 2007 could provide more momentum for consumer spending, while stronger demand from Asia and Europe could offset some of the negative impact from declining exports to the US.

The main risk is that the US recession could be deeper and longer than we currently forecast. This would drag the Canadian economy lower for longer. Nevertheless, the risks of a recession in Canada are low, in my view. Also, we could experience another round of credit market turmoil, as further big losses related to the US sub-prime crisis could be announced. This would lead to tighter credit conditions for both consumers and corporations.

By Charles St-Arnaud London
Morgan Stanley
January 16, 2008