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Professors' economic outlook upbeat for 2005
Strong GDP growth and low inflation predicted in Canada, with some cautions
December 08, 2004
Review of the old and prospects for the new
2004 turned out to be a year of steady growth for the Canadian economy. Driven by exceptionally strong global demand conditions, economic activity soared in the first half of the year. Low interest rates underpinned strong consumer and business investment spending. Although growth in the third quarter came in strong overall (3.2 percent on an annualized basis), this latest GDP report contains some worrisome elements. The report shows that exports declined in the third quarter and businesses built up substantial inventories of unsold goods. Economic activity actually shrank in September. Among many economic commentators, early-year wonder at the resilience of the Canadian economy in the face of the strong dollar has given way to some pessimism that the dollar’s most recent surge is crimping growth once again.
The Kingston economy appears to have shared in the strong overall performance of the economy. Although short-term local unemployment rates tend to be unreliable, the available data suggests a significant fall in Kingston-area unemployment starting in the spring. On the negative side, data just released by Statscan suggests that the strong dollar is having a noticeable impact on domestic and foreign travel, pointing to difficult times for the local tourist industry.
The panel was upbeat about the prospects for 2005. The consensus forecast is that real GDP growth will average 3.2 percent over the coming year. Although the global growth is likely to slow from its recent torrid pace, the panel expects that all of Canada’s main export markets will post strong showings. The biggest downside risk is probably significant further appreciation of the dollar. The US continues to rely heavily on foreign investors to fund its massive current account deficit. The US dollar is likely to fall much further if investors—particularly Asian central banks—lose their appetite for US assets. The result would be a substantial loss of international competitiveness for Canadian businesses.
With GDP growing at a rate close to the economy’s long-run non-inflationary potential, the panel is forecasting a slight decline in the unemployment rate to 7.1.
The inflation rate has been somewhat erratic over the course of 2004. It was low over the first part of the year, but rose over the second and third quarters as the prices of commodities (including oil) rose and capacity constraints tightened. The annual rate of inflation stood at 2.3 percent—just above the mid-point of the Bank of Canada’s target band—in October. However, when the most volatile components and the effects of indirect taxes are stripped out, the underlying core rate is stable and low.
More importantly, the Bank of Canada has been very successful in anchoring inflation expectations at around 2 percent. The panel believes that the Kingston business community can be confident in anticipating an inflation rate of 2 percent over short-, medium-, and even long-time horizons.
The movements of the inflation rate largely explain the movements of the Bank of Canada’s overnight target interest rate (and with it the business prime rate). Following the very weak growth performance and weak inflationary pressures in 2003, the Bank of Canada lowered its target interest rate on three occasions following the last Forecast Lunch. It then kept rates on hold over the summer as economic growth showed remarkable resilience. With signs inflation pressures gradually mounting, the Bank raised its target rate on two occasions later in the year. On December 7, however, it announced that it would keep rates steady for the moment, as it digests the third quarter GDP report mentioned above and also some disappointing employment numbers for November. As noted earlier, the panel did not believe that these recent weak numbers point to a significantly slowing economy. They forecast a half-percentage point rise in the target rate over the coming year, as the Bank returns to the task of bringing interest rates back to more normal levels. Over the next year, the panel is forecasting a slight rise in the business prime interest rate to 4.75 percent from its current rate of 4.25 percent.
Turning finally to the exchange rate, the panel—in common with all forecasters—found it a tough call. The first thing to be said is that last year’s panel did not foresee the appreciation of dollar that began in the early spring. This appreciation took the dollar from around 72 cents to over 84 cents at the end of November.
Has the dollar’s rise further to go? Although there was some disagreement on the panel, taking the average of the forecasts suggests that the exchange rate will hover around its current level of just over 83 cents. The entire panel agreed, however, that there is a real risk of a US dollar collapse. As noted above, this will happen if foreign investors are unwilling to keep accumulating the US dollar assets needed to finance the massive US current account deficit (5.5 percent of GDP). If such a collapse does occur, the Canadian economy will be in for a rough ride.