How Did Canada Get Into This Mess?

Canadians were relieved not to have succumbed to the irresponsible subprime-mortgage lending practices that were causing a collapse of the U.S. housing market. The Americans were suffering declining house prices, home foreclosures, a credit crunch, falling levels of employment, and a high and rising rate of inflation. There were fears that the United States was in fact in recession at that time. In Canada, meanwhile, employment was booming; inflation was low and stable; housing prices, while cooling, were moving up; and credit tightening was only a minor problem. Oil—which together with natural gas accounts for about half of the value of Canada's exports—was about $105 (WTI, U.S. dollars) in March, and was expected to average $91 over 2008. The Canadian dollar had been stable, averaging just below par since late 2007.

Flash forward to today. Like most other economic forecasters, Global Insight has significantly lowered its forecast for Canada's economic growth for 2008, from March's forecast of 1.6% down to just 1.2%. There is no one particular reason for this month's weaker growth forecast. Our forecast for exports in real terms is now slightly lower than it was in March, but the forecast for imports has been reduced even more. Weak energy prices are certainly not to blame; since March, oil has soared up to $145 and back down to the $120 level. Natural gas also moved up sharply, but has since receded to March levels. However, Global Insight's forecast for the average level of oil prices over 2008 is much higher today ($121) than it was in March ($91). Nor can exporters blame the Canadian dollar for deteriorating economic prospects; it is still expected to average just under par this year.

Overall, however, Canada's economic indicators have turned downward since March. Most of the decline in the forecast for economic growth for 2008 will be in consumer spending. Much more will be spent on gasoline in nominal (but not in real) terms, robbing the discretionary categories of consumer spending. Investment, both residential and business, now also seems on a slightly weaker path for 2008. Government spending will be slightly lower than earlier expected.

Meanwhile, 2008 is shaping up as a better year for the U.S. economy than expected in March, at least as far as economic growth is concerned. The U.S. economy is now expected to grow 1.6% in 2008, a heady improvement from the 1.2% forecast in March. Thus, since March, the 2008 growth forecasts for Canada and the United States have been reversed,

It is still true that employment is falling in the United States while it is rising in Canada, trends that also hold true for house prices. Home foreclosures are not a significant issue in Canada, while they continue at historically troublesome levels in the United States. U.S. inflation continues to be much higher than Canada's, likely to average almost 5.0% this year compared with Canada's 2.8%. When it comes to overall economic growth, however, the United States is definitely now expected to outpace Canada in 2008. U.S. investment now appears stronger, particularly fixed nonresidential investment. Federal government spending will also make a slightly larger contribution to economic growth in the United States in 2008 than forecasted in March.

Clearly, Canada cannot blame a deteriorating U.S. economy for the lowering of its 2008 growth prospects.

To further emphasize the mess Canada is currently in, the Bank of Canada, while forecasting even slightly lower growth for this year (1.0%) than Global Insight (1.2%), tells us not to expect it to stimulate the economy with lower interest rates anytime soon. First, impending inflation, threatening to surpass the 3% upper bound of the inflation target band later this year, argues against lowering interest rates in the near term. Second, the well-known "long and variable lags" of monetary policy prevent the Bank from rescuing Canada this year. Third, the federal government is not inclined to implement a fiscal stimulus package—thank goodness, since such efforts run the risk of being too little too late and far too tuned to political, as opposed to economic, recovery objectives. To rub even more salt into the wound, Canada's growth this year will not only be worse than that in the United States, it will be one of the weakest in the G-7, trailing only Italy's miserable 0.2%.

Optimists who seek some relief from the depressing forecast of 2008 can look ahead to the latter part of 2009. Global Insight, along with most private sector forecasters, expects the Canadian economy to be moving at about a 2.5% pace at that point, while the Bank of Canada is considerably more optimistic, at 3.0%. Most forecasters expect growth in the United States to take a dive late this year and early next year after the fiscal stimulus package has run its course. Growth in 2009 is therefore now expected to be stronger in Canada than in the United States.

We conclude, therefore, that while Canada is now in a much rougher spot than expected earlier this year, there appears to be light at the end of the tunnel, with a much improved performance by late next year.