Canada: A Major or Minor Slowdown?

Monetary conditions have tightened considerably since September 2005, when the Bank of Canada embarked on the last leg of interest-rate increases.The cost of overnight money rose from 2.50% to 4.25% in May. Meanwhile, the Canadian dollar appreciated 4 U.S. cents between September and July. Without any offsets to the tighter monetary conditions, GDP growth would likely downshift from its 3.0-3.5% pace in mid-2005 to about 2.0% over the next couple of years. As U.S. economic growth decelerates from more than 3.0% this year to about 2.6% next year, Canadian growth will be reduced by another 0.2–0.3 percentage point. This suggests GDP growth of about 1.5–2.0% in 2007, a major slowdown from the 2.9% pace in 2005. Why then do we expect growth of around 3.0% this year and only a slight downtick to 2.7% in 2007?

Let's start with our forecast for the third quarter. Although information is still very limited, it generally points to a rebound in GDP growth to about 3%. Narrow money—so-called M1+ that measures transactions demand—deflated by the Bank of Canada's core consumer price index provides the key corroborating evidence. Money-supply growth bottomed out in mid-2005, but has recently moved up, suggesting extra liquidity in the system to support solid growth in spending and investment.Output expectations by various business groups are consistent with the liquidity story. Manufacturers raised their outlook for production in the third quarter, after a dismal spring. In addition, small and medium-size businesses—representing close to half of Canada's economic output—continue to report a steady level of confidence, pointing to "good, but not spectacular growth in the economy." Finally, the Bank of Canada's survey of businesses also bodes well for stronger growth in the third quarter.

Going forward, Global Insight believes offsets from commodity prices and the housing market will moderate the extent of the coming slowdown. While natural gas prices fell more than 50% between September 2005 and July 2006, partly due to a warmer-than-usual winter, crude oil prices rose 14.4% during this period. Both natural gas and crude oil price are expected to rise next year. Global Insight looks for the Henry Hub natural gas price to jump 41.6% as winter temperatures return to normal. The cost of West Texas Intermediate crude oil is forecasted to rise from US$71.70 per barrel to US$76.25 on continued geopolitical tensions and a tight supply/demand balance.

Non-energy commodity prices increased 24.2% between September and July. Solid demand and insufficient supply will likely keep the prices of many metals elevated well into next year.The boom in commodity prices has lifted corporate profits and filled government coffers with windfall revenue. The impact of high commodity prices on GDP is difficult to estimate precisely, partly because it critically depends on the extent to which the higher prices have been driven by strong world growth. Still, it is fair to say that without this boom, business investment and commodity exports would have suffered, as would have government spending and the tax burden.

Regarding the housing market, further appreciation in home prices will add as much as 0.5 percentage point to the annualized rate of GDP growth by stimulating consumer demand through the end of next year. While new residential construction appears to have peaked earlier this year, price trends remain robust as builders have managed to keep the stocks of unsold homes to a minimum. The ratio of sales to new listings remains high, indicating a price-supportive sellers' market. In fact, gains in new home prices have picked up since mid-2005. Moreover, the Canadian Real Estate Board reports that average resale prices have been rising at a 10%-plus year-on-year pace over this same period. The appreciation of real estate values has boosted households' net worth and supports expectations of more gains to come, even if at a slower rate.

With the sizable tightening in monetary conditions since last September and the prospective deceleration of U.S. demand, a reduction in Canadian growth is inevitable. The recent monthly GDP numbers indicate a worrisome loss of momentum in the economy. So long as commodity prices remain elevated and Canadian house prices continue to appreciate, however, the slowdown will be minor rather than major.