Canadian Growth Risk: How Good or Bad Can It Get, Reasonably?

• A dramatic 27% decline in U.S. housing starts to 1.3 million units in 2007 would not, by itself, be sufficient to cause a U.S., let alone Canadian, recession—even if the Bank of Canada failed to cut rates. The assumed hard landing in U.S. residential construction would cut Canada's GDP growth to 2.1% in 2007, from 2.6% in Global Insight's base case.
• In the case when the Bank of Canada makes a 50-basis-point insurance cut that, ex-post, is not needed due to solid U.S. growth, it would have plenty of time to rewind the stimulus without putting at risk the credibility of the inflation-targeting regime. The insurance rate cut would lift Canadian GDP growth in 2007 by a significant, but small, 0.1 percentage point.

The shape of the U.S. economy after the sizable Fed tightening is the main concern of policy makers and business leaders in Canada. Indications from the housing market suggest a greater slowdown in sales and construction stateside than many had anticipated. Meanwhile, inflation remains above the Fed's comfort zone, lending a tightening bias to monetary policy. Global Insight has a relatively bearish forecast for the U.S. economy, calling for GDP growth of somewhat above 2% in 2007. Some forecasters, however, expect growth closer to 3%, in part due to the beneficial influence of lower oil prices.

In this risk analysis, we explore the implications for Canada of two scenarios for the U.S. economy. In the pessimistic scenario, the landing of the U.S. housing market is much harder than even in our baseline forecast. In the optimistic scenario, lower inflation and favorable productivity growth propel the American economy at a pace of slightly over 3% in 2007.

In a slight twist to the tale, we assume the Bank of Canada makes (ex-post) wrong decisions on interest rates in both cases. It keeps interest rates unchanged when the U.S. residential construction crashes, while it cuts rates, as in the baseline, when the U.S. continues to perform well.

Pessimistic Scenario: U.S. Housing Construction Tanks (10% Probability)

The U.S. housing market has performed above expectations for many years, in terms of both prices and the level of housing starts. In the pessimistic scenario, Global Insight assumes that the correction in the housing market is harder than assumed in the base case. In particular, housing starts drop 27.2% between 2006 and 2007, compared with an 8.6% decline in the base scenario. The greater decline in home construction causes much weaker GDP growth stateside: 1.7% in 2007 compared with 2.4% in the baseline.

Canadian exports are directly affected by the weakness in the U.S. economy. Instead of rising 0.7% next year, as in the base projection, they fall 1.2%. Exports of forestry products, machinery and equipment, and consumer goods other than autos are particularly hard hit. Growth in the Canadian economy bottoms out at slightly below 2% in the middle of 2007, with GDP rising 2.1% for the year as a whole.

The Bank of Canada is assumed to stay on the sidelines and keep the overnight rate at 4.25% through the end of 2007. It could be reasonably expected to start cutting rates by mid-2007, as the economy would show little indication of strengthening and the unemployment rate would be on an upward trend. Even if the bank did lower the overnight rate by 50 basis points by early 2007, this would not prevent most of the slowdown, as it would raise 2007 growth by only a 0.1 percentage point.

Optimistic Scenario: U.S. Economy Stays Strong, Inflation Recedes on Lower Oil Prices (5% Probability)

This scenario makes several favorable assumptions for the U.S. economy: faster productivity growth, firmer foreign demand, stronger business investment, lower energy prices, and higher housing starts. Housing starts decline only 0.9% next year. Crude oil prices stay little changed between this year and next, averaging about US$67.5 (WTI crude) per barrel compared with the increase to US$76.3 in the baseline. Natural gas prices are also weaker than in the base case. As a result, the U.S. economy grows 3.2% next year.

The stronger U.S. growth translates into faster Canadian exports, which rise 1.7% next year. In turn, Canadian GDP expands 2.8%. The assumed 50-basis-point reduction of the overnight rate by early 2007 raises GDP growth by 0.1 percentage point next year, not enough to cause concerns about overheating. Canada's growth bottoms out at 2.6% in the fourth quarter of this year and the first quarter of 2007. The pickup in the pace of activity to 3.5% by late next year could prompt a rewinding of the Bank of Canada's insurance rate cuts.

by Wojciech Szadurski