U.S. Recession Woes Weigh on the Canadian Economy

In this risk analysis, Global Insight explores the U.S. recession fears that have recently hit the headlines. In the United States, estimates of GDP growth in the third quarter went from strong to surprisingly stronger, while the deterioration in the subprime mortgage market remains a drag. On the other hand, Canada's economy is still relatively healthy and employment growth is very solid. The pessimistic scenario focuses on the risk of a U.S. recession. The optimistic one incorporates a situation in which several favorable developments allow the American economy to grow faster than in the baseline.

Although the latest three quarters of U.S. economic growth have been robust, the impact of the subprime mortgage fiasco has yet to hit the GDP numbers. The housing recession is definite, and is the biggest drag on the U.S. economy. Home prices will fall for the first time in 2007, and the inventory of unsold homes is still problematic. The spillovers will result in a pullback of consumer spending and a re-adjustment of the U.S. financial system.

The ground on which the economic bulls stand on is getting very wobbly. The risks from the housing market and the credit crunch have worsened, but the freeze on interest rates for some subprime borrowers may limit the impact of a general recession. Oil prices were in the US$100/barrel range, but have recently dipped below $90 and should drop further still in 2008. The bright spot in the economy is the quickened pace of employment growth in Canada and decent employment growth in the United States. So, while fourth-quarter U.S. economic growth of 1.3% will in no way match that of the previous two quarters, the economy is expected to hum along at a moderate pace.

Pessimistic Scenario: U.S. Recession

(40% Probability)

Global Insight's baseline U.S. forecast assumes that housing starts will plunge below 1 million units and stay there for all of 2008 and the first quarter of 2009. These levels are close to the lows hit in the previous housing market corrections. Annual existing home prices will fall for the first time across the nation. And although the estimated degree of the subprime mortgage problems is not fully known, future mortgage borrowing will be much more restrictive.

The pessimistic scenario assumes that the U.S. housing market will bottom out around 800,000 units for starts, and stay there longer than the baseline case. The extended downturn in the housing market weakens residential construction spending more than in the baseline, resulting in the U.S. economy falling into a recession. U.S. real GDP suffers a downturn for three quarters starting in the fourth quarter of 2007, with the U.S. economy enduring the worst outcome in the first quarter of 2008. Oil prices climb, and the Federal Reserve cuts the fed funds target rate, dropping it to 3.5% by mid-2008 before there is a recovery in the third quarter of 2008.

The Canadian economy is not be immune to a U.S. recession, at least not in this scenario. As the U.S. economy retreats, foreign demand for Canadian products cools. Dampened exports and lower commodity prices take the steam out of the pace of investments in the resource sector. The Canadian dollar does little to offset the decline, as the loonie stays around par during throughout 2008 and falls to the mid 90s starting in 2009.

Even though the U.S. economy experiences a recession in this scenario, the Canadian economy, while weakening, does not. Real GDP for Canada expands at an anemic 0.9% pace in the first and second quarters of 2008. The unemployment rate jumps to 6.3% by the third quarter of 2008 and climbs to 6.6% for 2009. This is above our baseline forecast of 6.2% for 2009. There is only a slight two-quarter reprieve on CPI inflation during the first half of 2008. The Bank of Canada tempers the economic slowdown and the cooling pressure on prices by cutting the overnight rate to 3.75% during the first quarter of 2008, but then resumes tightening throughout 2008.

Optimistic Scenario: Rosy Outlook for the U.S.

(5% Probability)

In the optimistic scenario, the U.S. economy expands at a much quicker pace than the baseline as oil prices ease significantly from their recent highs. Improving labor productivity growth boosts GDP, lowers inflation, and strengthens the U.S. dollar. Falling energy prices keep inflation pressures in check. Softer prices spur consumer demand, allowing the Fed to cut interest rates, which in turn boost the U.S. economy. Under this scenario, real GDP growth averages 2.8% in 2008 and 3.7% in the following year. The fed funds rate falls to average 4.3% in 2008.

With a boost in the U.S. economy, demand for Canadian goods rises, lifting our export growth. However, the value of exports may be somewhat subdued as oil prices slide. The Canadian dollar falls about a penny, providing further stimulus to exports. Canadian economic growth averages 2.6% in 2008 and 2.8% in 2009, both higher than the 2.4% predicted in the baseline for each year. The Bank of Canada, concerned with stronger economic growth, increases the overnight rate, raising it 50 basis points to 4.75% throughout 2008, as opposed to holding steady at 4.25% as in the baseline.