Canadian National Accounts Data: Flash Report and Implications for Monetary Policy

Growth in the second quarter was fueled by consumer spending, particularly on autos and home appliances. Retail sales were generally strong, driven by healthy income and employment growth. Fortunately, business investment also picked up. This uptick in investment of machinery and equipment bodes well for a much needed improvement in Canada's productivity and future economic potential. Exports, except for autos, also contributed to growth.

Readers may be tempted to dismiss these second-quarter results, after significant turmoil in financial markets, with serious threats for weaker real economic growth going forward, burst upon us in early August. The key implication of these second-quarter results, however, is that they tell us the Canadian economy was operating at a higher level of output and moving at a more robust pace than earlier thought.

In July, the Bank of Canada believed the economy was operating in a position of slight excess capacity. After having increased interest rates on July 10 the Bank still felt that "some modest further increase" in the policy rate would be required to bring inflation down to its appropriate level. With the economy operating at a higher level of output than previously understood, this means that in July, the Bank of Canada actually underestimated the threat of inflation going forward.

It is very clear to Global Insight, as well as most other economists and financial markets, that the Bank will hold rates steady on September 5, given the significance of the financial turmoil and the uncertainty of the degree to which its indirect impacts will reduce Canada's rate of economic growth below the previous forecast over the next year.

The key issue from both the economic policy perspective and the financial markets perspective now is, "How much weaker will the economy be going forward than previously believed?" Will the indirect effects of the financial sector turmoil be so negative on Canada's real growth over the next year that they will reduce the (excess demand) output gap quickly and significantly below where it is today, and even below where it was forecasted in July to be at year-end?

Global Insight expects that the U.S. economy will be weaker than previously forecasted, particularly in 2008, in spite of a 50- or even 75-basis-point reduction in the policy rate by the Fed before year-end 2007. We expect the Bank of Canada and others will be reasonably comfortable with their forecast of the Canadian economy before year-end. Therefore, Global Insight expects that before year-end, the Bank of Canada will pick up where it left off in July, and proceed with some modest tightening.

We now turn to the impact of the above results and analysis on Global Insight's economic forecast. These second-quarter results are stronger than we had anticipated. However, the financial turmoil beginning in early August will bring indirect impacts to weaken economic growth, just slightly for the second half of 2007, but with more negative impacts for the first half of 2008. It appears that policy interest rates will be increased by the Bank of Canada later in the year than expected, but will still end 2007 at 4.75% as earlier expected. One implication of today's results is that it makes it almost certain that, in 2007, for the first time since 2002, Canada will have a stronger rate of economic growth than the United States.

The full and final impact of this new National Accounts data on Global Insight’s September 2007 short-term forecast awaits a thorough analysis and running of our econometric model. Global Insight expects to complete the data bank for the September Canadian Short-term Forecast and Analysis next week and will provide our Preliminary Report at that time.