Chapter 1
Recent Economic Developments and Prospects

Highlights

• Notwithstanding weakness in the U.S., economic growth in Canada continues to be strong. Real gross domestic product (GDP) grew 3.4 per cent in the second quarter of 2007, following 3.9 per cent growth in the first quarter.

• Private sector forecasters expect real GDP growth of 2.5 per cent in 2007, 2.4 per cent in 2008 and 2.7 per cent in 2009.

• The private sector forecast for growth in 2007 is up from the 2.3 per cent forecast at the time of the March 2007 budget, balancing stronger-than-expected GDP growth for the first half of the year and weaker growth in the second half.

• As well, GDP inflation has been revised up significantly to 3.3 per cent from 1.5 per cent at the time of the budget.

• Stronger-than-expected growth in the first half of 2007 and higher GDP inflation mean that the level of nominal GDP—the broadest measure of the tax base—is now expected to be close to 1.9 per cent higher in 2007 than forecast at the time of the budget.

• However, the risks to the Canadian economy are tilted to the downside.

• A significantly weaker U.S. housing market and tighter credit conditions have added uncertainty to the U.S. economic outlook.

• The Canadian dollar has traded above parity with the U.S. dollar for the first time in 30 years, due in part to continued increases in commodity prices and generalized U.S.-dollar weakness. This is increasing pressure on our trade sector.

• The Government is determined to act from a position of strength to respond to the growing global uncertainties.

Notes: This chapter incorporates data available up to and including October 19, 2007. Figures are at annual rates unless otherwise noted.

Introduction

This chapter reviews recent economic developments and prospects. It first discusses recent developments and the outlook for the U.S. and global economies. Second, it reviews recent economic developments in Canada. Third, it describes the average private sector economic forecast that forms the basis for the Government’s fiscal projections and discusses the risks and uncertainties associated with the economic outlook.

A central conclusion of this chapter is that the Canadian economy is very strong. At the same time, there are a number of global uncertainties. The impact of the rapid rise of the Canadian dollar has yet to be fully realized. Further, the effects of recent turmoil in global financial markets and a declining U.S. housing market continue to pose challenges. These global uncertainties highlight the importance of putting in place measures to alleviate the potential downside risks to the economy.

U.S. and Global Economic Developments and Outlook

Recent U.S. Economic Developments

The U.S. economy has been growing at a moderate pace since the second quarter of 2006, with real GDP growth averaging 2.9 per cent in 2006 and 2.2 per cent in the first half of 2007. This moderate growth masks a significant decline in residential investment, which to date has been offset by ongoing growth in consumer spending and business investment (Chart 1.1).

Recent data suggest that the contraction in U.S. residential investment will be deeper and more prolonged than previously anticipated (Chart 1.2). Housing starts continue to decline, inventory-to-sales ratios remain elevated and house prices are falling.

Over the past year, delinquencies on subprime mortgages have increased significantly (Chart 1.3). This has caused numerous subprime lenders to fail and has resulted in substantial losses for holders of securities backed by subprime mortgages. As a result of these developments, new subprime mortgage originations have virtually come to a halt.

Since August, weakness in the subprime market has spread more broadly to financial markets, leading to a widespread reassessment of risk. Investors have retreated from asset-backed securities, while corporate bond spreads have widened, especially on lower-quality debt. As well, yields on short-term Treasury bills have fallen, reflecting a flight to quality.

In response to the ongoing financial market turbulence and concerns that the sharp contraction in residential investment could have adverse effects on the broader economy, the Federal Reserve cut its target for the fed funds rate by 50 basis points on September 18. In addition, the Federal Reserve and central banks around the world, including the Bank of Canada, took measures to inject liquidity to support the efficient functioning of financial markets.

U.S. Economic Outlook

As a result of developments in U.S. housing and financial markets, there is considerable uncertainty about the outlook for the U.S. economy. The central question is whether the recent cut in the federal funds rate, together with the depreciation of the U.S. dollar, will be sufficient to offset the impact of tighter credit conditions and a weaker housing market.

Overall, private sector forecasters expect economic growth to remain well below trend growth in the second half of 2007 and through most of 2008. For 2007, private sector forecasters expect real GDP to grow by only 1.9 per cent. In 2008, growth is expected to be 2.2 per cent before strengthening to 2.9 per cent in 2009. Relative to forecasts prepared at the time of the March 2007 budget, U.S. economic growth has been revised down by 0.6 percentage points in 2007, 0.7 percentage points in 2008 and 0.4 percentage points in 2009 (Chart 1.4).

Growth in consumer spending is expected to moderate as a result of slower growth in household wealth. Although there are no signs at present, it could slow further if ongoing weakness in the housing market reduces consumer confidence further. Business investment should grow at a solid pace, reflecting the expectation of ongoing profitability, but should be tempered somewhat by higher borrowing costs and increased uncertainty about the economic outlook. For the first time in 11 years, net exports are expected to contribute to growth, reflecting continued strong global demand and reduced U.S. demand for foreign imports. This trade performance has also helped reverse the steady deterioration in the U.S. current account deficit.

Global Economic Outlook

Despite the weakness in the U.S. economy, the global expansion is expected to continue at a solid pace. Overall, robust growth in emerging market economies, including China, is expected to offset a modest slowing of growth in advanced economies. The International Monetary Fund (IMF) expects world real GDP growth (calculated at market exchange rates) to ease from 3.8 per cent in 2006 to 3.5 per cent in 2007 and 3.3 per cent in 2008 (Chart 1.5).^[1]

Japan’s economic recovery was interrupted in the second quarter of this year, as a fall in business investment led to a contraction in the overall economy. Growth in Japan is expected to moderate to 2.0 per cent in 2007 and 1.7 per cent in 2008 from 2.2 per cent in 2006, with consumption and investment being the main drivers of growth, supported by income gains and healthy profits.

The euro zone has expanded at a brisk pace since mid-2006, aided by an upswing in investment (particularly in Germany) and growth in exports. Growth is expected to remain strong as improved job market conditions support household spending, high profitability is expected to boost investment and exports are expected to remain robust. The euro zone is projected to expand by 2.5 per cent in 2007 before easing to 2.1 per cent growth in 2008.

China’s economy continues to grow rapidly and unevenly, led by surging investment and exports but with relatively weak domestic consumption. The IMF expects the Chinese economy to expand by at least 10 per cent in both 2007 and 2008. Consumer price inflation has risen and is projected by the IMF to be 4.5 per cent this year. Growth could exceed expectations if authorities fail to cool the economy through a series of measures, including faster appreciation of the currency and tighter monetary policy. On the downside, with a current account surplus projected to be roughly 12 per cent of GDP in both 2007 and 2008, China’s reliance on the U.S. and global markets remains substantial. As a result, slower growth in the U.S. could weigh on China’s economic outlook.

Canadian Economic Developments

The Canadian economy grew by 3.4 per cent in the second quarter of 2007, following 3.9 per cent growth in the first quarter (Chart 1.6). Strong final domestic demand has supported growth since 2001.

Labour markets remain tight, with more than 280,000 new jobs created to date in 2007. All regions of the country have benefited from this gain (Chart 1.7). These employment gains follow 14 consecutive years of solid employment growth, reducing the unemployment rate to its lowest level in almost 33 years. Employment growth has been particularly strong in B.C., the Prairies and Quebec this year. In Ontario, weakness in the manufacturing sector has been offset by strong growth in the service sector.

Commodity prices have remained at record highs in recent months. Since January 2007, commodity prices measured in U.S. dollars have increased 11 per cent, led by higher energy and agricultural prices (Chart 1.8). West Texas Intermediate crude oil prices traded at a record high of more than US$90 in October, reflecting strong global demand, falling inventories and heightened geopolitical concerns. Agricultural prices have increased 41 per cent since April 2006, reflecting rapid economic growth in many low-income countries; increasing demand for feed-intensive meat products; and greater production of bio-fuels, which has created another source of demand for agricultural commodities. However, natural gas prices are down by about 5 per cent since the first quarter of 2007.

Corporate profits have been supported by strong domestic demand, elevated commodity prices and lower prices for imported inputs. As a result, they remain near their record highs (Chart 1.9).

Strong profits have boosted investment, particularly in the oil and gas sector, which accounts for about one-fifth of total non-residential investment in Canada. Furthermore, the appreciation of the Canadian dollar, which has lowered the costs of imported machinery and equipment (M&E), has boosted M&E investment volumes.

Overall inflation has remained low and stable, although core inflation (which excludes the eight most volatile components of the overall index as well as the effect of indirect taxes) has trended up somewhat over the last two years. In September, total Consumer Price Index (CPI) inflation was 2.5 per cent and core CPI inflation was 2.0 per cent after having remained above the 2 per cent mid-point of the Bank of Canada’s target range since August 2006 (Chart 1.10). This has been due in large part to strong growth in home replacement costs (the current cost of replacing a damaged house), homeowners’ insurance costs and core food prices. Since July 2007, the Bank of Canada has held its policy rate at 4.5 per cent.

Starting in mid-June, but intensifying in August, markets worldwide repriced risk across a broad range of assets, resulting in a sharp fall in liquidity. Major central banks including the Bank of Canada, provided significant amounts of liquidity to their financial systems to maintain their policy interest rates at targeted levels.

Reflecting these developments, borrowing spreads between traditional commercial paper and Government of Canada treasury bills have risen in recent months. The 3-month paper rate reached a high of 5.27 per cent on September 18 from 4.74 per cent on August 1, while 3-month treasury bill rates have dropped significantly, resulting in the 3-month spread increasing to a high of 131 basis points on August 24 (Chart 1.11). Short-term spreads of this magnitude have not been seen in Canada for 26 years. Although spreads in Canada and abroad have recently narrowed, liquidity in money markets remains below historic norms.

The Canadian market for non-bank asset-backed commercial paper (ABCP), which totals about $34 billion, has been particularly affected. Under the Montreal Accord, a pan-Canadian committee representing investors holding securities issued by the affected ABCP conduits is in the process of negotiating a restructuring proposal with the conduits’ counterparties and liquidity providers. On October 15, 2007, the investors’ committee announced an extension to the standstill agreements underlying the Montreal Accord to December 14, 2007. This process should result in an orderly market-based workout of the affected securities.

The Canadian dollar reached parity with the U.S. dollar on September 20—the first time since 1976 (Chart 1.12). The strength of the Canadian dollar partly reflects ongoing gains in the terms of trade (export prices relative to import prices) as rising prices for oil and other commodities have boosted Canadian export prices and the higher dollar has lowered import prices.

However, the recent strength of the dollar cannot be explained by changes in commodity prices alone. Rather, the recent strength in the dollar has also been fuelled by interest rate differentials and the ongoing adjustment to global current account imbalances. Since the beginning of 2002, on a trade-weighted basis, the U.S. dollar has depreciated by over 20 per cent against a broad group of currencies. Over this period, Canada has accounted for more than one-third of the depreciation of the U.S. dollar. The entire euro area accounts for another third of the adjustment, with the rest of the world accounting for the remainder. Canada has clearly borne the brunt of the U.S.-dollar adjustment.

The appreciation of the Canadian dollar is causing significant adjustment to the economy. The higher dollar presents a significant challenge to exporters, in particular to manufacturers, and to domestic producers who compete with foreign producers in the Canadian market. The manufacturing sector has been impacted the most over the past two years, with real output declining by more than 3 per cent and employment declining by more than 130,000 since December 2005.

The manufacturing sector’s share of total output has been declining in all Group of Seven (G7) countries over the past 35 years (Chart 1.13). This long-term trend reflects an ongoing shift in the location of manufacturing activity to low-cost manufacturing countries as well as the increasing importance of the service sector. In Canada, manufacturing’s share of the economy grew solidly between 1993 and 2000, supported by the low Canadian dollar during that period. Since then, the sharp appreciation of the Canadian dollar has put downward pressure on manufacturing exports.

The decline in manufacturing output since the end of 2005 has been particularly pronounced in wood and related products, automobiles and textile industries (Chart 1.14). Manufacturing of wood and related products has experienced a steep drop in output in response to the deterioration of the U.S. housing market since early last year. Production of motor vehicles and parts fell for much of 2006 and in early 2007, reflecting sluggish North American demand for automobiles and restructuring by the Big Three U.S. automakers. The clothing and textile industry continues to be affected by competition from low-cost countries such as China.

The higher dollar also brings with it a number of benefits, which to date have supported a significant increase in Canadians’ standard of living. The first benefit is to lower the price of imported machinery and equipment (M&E), which supports investment. Since early 2002, when the dollar began to appreciate, the price of M&E has declined by 18 per cent. By lowering the cost of imported M&E, the appreciation of the Canadian dollar has helped to boost the volume of M&E investment, which has increased 48 per cent since early 2002, mirroring the increase during the high-tech investment boom (1996–2000). In contrast, investment in equipment and software in the U.S. has grown at a much slower pace since 2002. Recent enhancements to capital cost allowance rates will further support investment in Canada.

The second benefit of the higher dollar is to reduce the price of imported consumer goods. Although it is difficult to isolate the impact of the dollar from other factors such as advancements in technology, the prices of certain imported consumer goods have declined since the Canadian dollar began to appreciate in 2002, especially prices of household appliances and audiovisual equipment (Chart 1.16). As a result, Canadians’ real purchasing power has risen. It is reasonable to expect that competitive pressure will reduce the prices of imported goods in response to the higher dollar.

The same factors that have contributed to the appreciation of the dollar have led to a strong increase in Canadians’ living standards, as measured by real per capita incomes (Chart 1.17).

Canada’s terms of trade (export prices relative to import prices) have increased by 23 per cent since the fourth quarter of 2001. Increases in export prices have been supported by substantially higher prices for commodity exports. At the same time, import prices have been on a strong downward trend due to the significant appreciation of the Canadian dollar and the increased availability of low-cost imports from emerging countries (Chart 1.18). The resulting terms of trade improvement has boosted Canadians’ real per capita incomes by 7.6 per cent since the end of 2001.

As well, an increasing share of income generated in Canada is staying in Canada, while Canadians are also earning more income from other countries. A shift from large government deficits in the early 1990s to surpluses has reduced Canada’s reliance on foreign sources of funds and reduced the resulting outflow of payments to foreigners. The resulting improvement in Canadians’ net international investment income has boosted real per capita income of Canadians by 2.4 per cent since the end of 2001.

Overall, improving terms of trade and net international investment income in Canada have led to real per capita incomes growing almost twice as fast as real per capita output over the past 51⁄2 years.

Private Sector Economic Forecasts

The Department of Finance surveys private sector economic forecasters on a quarterly basis. The economic forecasts reported here incorporate economic data through October. The average of private sector forecasts forms the basis for economic assumptions that underlie the fiscal projections reported in the next chapter.

Short-Term Outlook

Since the March 2007 budget, real GDP growth and GDP inflation (which is measured as the change in the average price of goods and services produced in Canada) have been stronger than expected (Chart 1.19). At the time of the budget, forecasters expected real GDP growth to average 2.6 per cent in the first half of the year, a full percentage point below actual growth.

GDP inflation in the first half of 2007 was four times higher than expected at the time of the budget. This occurred because of continued gains in Canada’s terms of trade as well as higher consumer prices. GDP inflation was further boosted by one-time government payments relating to the Quebec pay equity settlement and pension payments by the Newfoundland and Labrador government.

However, for the second half of 2007 and through 2008 and 2009, private sector forecasters now expect nominal GDP growth to be lower than forecast at the time of the 2007 budget (Chart 1.20).

Forecasters now anticipate real GDP growth of 2.4 per cent in 2008 and 2.7 per cent in 2009, down from 2.9 and 3.1 per cent, respectively, in the budget forecast. The downward revision to the growth outlook primarily reflects weaker U.S. growth, due to unexpected sustained weakness in the U.S. housing market, the impact of a stronger dollar on the export sector as well as the effects of ongoing financial market uncertainty.

Private sector forecasters have sharply revised upward their forecast for GDP inflation in 2007 to 3.3 per cent from 1.5 per cent in the budget. Forecasters expect GDP inflation to ease to 2.4 per cent in 2008, moderately higher than anticipated at the time of the budget, and to 2.0 per cent in 2009, as anticipated in the budget.

As a result, nominal GDP is projected to grow 5.9 per cent this year and 4.8 per cent in 2008, compared to 3.9 per cent and 5.0 per cent, respectively, in the budget forecast. Private sector forecasters expect nominal GDP growth of 4.7 per cent in 2009, down from 5.2 per cent anticipated at the time of the budget. Relative to the private sector forecast presented in the budget, the level of nominal GDP is now expected to be close to $29 billion higher in 2007, $27 billion higher in 2008 and $20 billion higher in 2009 (Chart 1.21).

Short-term interest rates are expected to average 4.2 per cent in 2007 and 4.4 per cent in 2008, 20 basis points higher than the budget forecast. Private sector forecasters expect that short-term rates will then rise somewhat, averaging 4.7 per cent in 2009 compared to 4.3 per cent forecast at the time of the budget.

Private sector forecasters expect Canadian long-term interest rates to average 4.3 per cent in 2007 and 4.6 per cent in 2008—modestly higher than they had forecast in the budget. For 2009, private sector forecasters expect long-term interest rates to average 5.0 per cent, down slightly from their budget forecast.

Private sector forecasters expect the Canada-U.S. exchange rate to average close to 92 U.S. cents in 2007, consistent with a level of approximately 97 U.S. cents over the remainder of this year. Forecasters expect the exchange rate to remain close to this level in 2008 and 2009.

Forecasters expect the Canadian labour market to remain healthy. The unemployment rate is expected to average 6.1 per cent in 2007 and 6.2 per cent in both 2008 and 2009, modestly below levels anticipated at the time of the budget.

Medium-Term Outlook

Private sector forecasters have not significantly changed their medium-term economic outlook since the budget. Real GDP growth is expected to average 2.8 per cent from 2010 to 2012. Nominal GDP growth is projected to average 4.4 per cent over the period, moderately lower than the budget forecast, reflecting lower GDP inflation. Short- and long-term interest rates are expected to average 4.6 per cent and 5.0 per cent, respectively, over the medium term. The unemployment rate is expected to remain near current levels over the 2010 to 2012 period.

Table 1.1
Private Sector Forecasts for 2007–2012

Risks and Uncertainties

The risks to the Canadian economic outlook are tilted to the downside. The main risks to the outlook are the potential for a weaker U.S. economy and a higher-than-expected Canadian dollar. There are also modest upside risks to the Canadian outlook. Consumer and business spending could be stronger and residential investment may not slow as expected, given continued strong income and profits.

The Government is determined to act to respond to the growing global uncertainties and help secure the current strength of the economy for the future. This requires long-term structural measures to deal with the competitive challenges facing the economy.

Weaker U.S. and Global Growth

Private sector forecasters expect a significant further contraction in the U.S. housing market, which could put further pressure on U.S. house prices and household finances, resulting in a larger impact on U.S. consumer spending than was previously expected. A weaker U.S. outlook would reduce demand for Canadian exports destined for U.S. markets. As well, it is possible that the U.S. housing market could deteriorate even more than expected.

Moreover, there is a risk that recent turbulence in global financial markets could be prolonged, resulting in higher business and consumer borrowing costs, reduced credit availability and weaker consumer and business confidence. This would negatively impact both consumer spending and business investment in the U.S. and globally, although the impact on the U.S. would likely be greater given the already-weakened state of its economy. These developments would have negative implications for Canadian growth in addition to somewhat tighter domestic credit conditions.

Exchange Rate

Based on the private sector forecast, the dollar is projected to depreciate to 96 U.S. cents in 2008 and 95 U.S. cents in 2009. This is well below the current trading level of the dollar. If the Canadian dollar were to remain close to recent trading levels, this would pose a downside risk to the trade sector and to overall economic growth. Further, recent increases of the dollar may reflect generalized U.S.-dollar weakness and speculative sentiment toward the Canadian dollar rather than domestic fundamentals.

¹ The IMF reports world real GDP growth on both a market exchange rate and a purchasing power parity (PPP) basis. On a PPP basis, the IMF expects world real GDP growth to ease from 5.4 per cent in 2006 to 5.2 per cent in 2007 and 4.8 per cent in 2008.[Return]