Canadian economy is cooling, but will remain strong through 2019

Dan North
Dan North North American Chief Economist

The Canadian economy is expected to continue exhibiting solid fundamentals through the rest of 2018 into 2019. The economy is running near its potential growth rate and leading indicators suggest solid performance over the next 6 to 12 months. The relief that a new trade agreement has been formed along with an easing of concerns over a housing market bubble are supportive to consumer and business confidence. The GDP forecast for all of 2018 remains at 2.1%, but is expected to cool in 2019 towards a more sustainable 1.9%.

Canada was the strongest economy in the G-7 in 2017, running at a relatively hot GDP growth rate of 3.0% y/y. However that pace is unsustainable in the long run, and so the economy is cooling towards a more typical rate. As shown in the chart, the “output gap”, which is the difference between the economy’s actual and potential performance, has shrunk to virtually nothing, meaning that the economy is running as fast as it should be given its existing labor, capital, technology, and demographics.

Typically as the output gap closes, inflationary pressures start to emerge in the economy. One of the Bank of Canada’s (BoC) favored measure of inflation is the average of its three core measures of inflation as shown below, and that has clearly been on the rise for the last year and a half. This increase in inflation, along with concerns about a housing bubble and an over-heating economy, caused the BoC to start raising the policy overnight rate in the middle of 2017 from 50 bps where it had been for two years. As core inflation continued to increase, the BoC did not hesitate to act and has raised rates four more times since then. The BoC’s most recent hike was on October 24th, from 1.50% to 1.75% and the accompanying information was quite a bit more hawkish than before. Most notably the policy statement dropped the word “gradual” in respect to its pace of future rate hikes, suggesting that it could start hiking faster than previously thought. There were several other hawkish notes that all pointed to more increases in the pipeline. Governor Poloz said “we are being simulative at a time when the economy doesn’t appear to need it” perhaps referring to the fact that the real overnight rate is still negative at around -0.7% (compared to the Fed Funds rate that is just about 0%). The statement also read that “the policy interest rate will need to rise to a neutral stance to achieve the inflation target”; 1.75% is well short of the neutral rate as defined by the BoC of between 2.5% and 3.5%. In addition the statement noted that the new USMCA had reduced trade uncertainty. The more hawkish bias certainly implies more hikes coming, perhaps as early as December, but more likely January. Remember that despite the fact that rate hikes will eventually be a drag on the economy, they are a sign that the central bank sees a thriving economy.

And that’s what leading economic indicators are showing as well. The BoC’s Business Outlook survey reached its second highest level ever (since 2002) in Q2-18 although it has retreated slightly since then. The text of the autumn survey painted a portrait of a very strong economy:

  • Building on an improvement in sales over the past 12 months, firms expect sales growth to increase further. Reports of better sales indicators for domestic and foreign customers are widespread.
  • Driven by both strong demand and capacity constraints, the investment indicator rebounded to a high level. Hiring intentions have receded but are still positive across all regions and sectors.
  • … labour shortages have intensified over the past year have reached near-record levels.
  • Input and output prices are expected to grow at a faster pace, with several firms anticipating upward cost pressure from tariffs. A majority of firms continue to expect inflation to be in the upper half of the Bank's inflation-control range.

Similarly, the Canadian Federation of Independent Business (CFIB) Business Barometer survey remains quite optimistic despite having declined slightly over the past two quarters. When the results of the survey are >=50, it means that business conditions are anticipated to be stronger over the next 12 months, and its current level of 60 (three month average) is quite robust. 

Meanwhile, a major risk to the economy has receded somewhat. Over the past few years, foreign investors, particularly from China, have bid up housing prices at an unsustainable pace, particularly in Vancouver and Toronto. In response, local, provincial, and federal governments took measures to cool off the market including taxing foreign purchases and tightening mortgage lending standards. These measures have indeed cooled off the market, and according the BoC’s policy statement “…housing activity across Canada is stabilizing. As a result, household vulnerabilities are edging lower in a number of respects, although they remain elevated.” In addition the October Monetary Policy Report stated that “… housing activity is moderating to a more sustainable level. … (government) rule changes also appear to have helped take the wind out of the sails of speculators in some markets, which reduces the pressure on housing affordability.” The charts show that indeed prices were driven down sharply on a y/y basis but are now growing again on a m/m basis, unit sales were driven down sharply from unsustainable rates, but are now recovering, and housing starts have fallen towards more normal levels.

Finally, one other major risk to the economy has disappeared and instead has been turned into a positive. The creation of the new US – Mexico – Canada Agreement (USMCA) trade accord is a major relief. The possibility that NAFTA would disappear and that Canada would be left out of the new accord weighed on the economy. While Canada did have to make concessions on the new USMCA, the agreement is quite similar in principle to NAFTA. Some differences include changes to the rules of origin for autos and allowing the US greater access to the Canadian dairy market. However the new USMCA does not remove tariffs on steel and aluminum exports to the US, and the tariffs on softwood exports remain as well.

What it means for your business

While the economy is in fine shape overall at the moment, there are still some risks to look out for. Business conditions in the metals industry are challenging as Canada is the leading exporter of steel and aluminum into the U.S. The new USMCA does put Canadian dairy farmers at some risk since their market is now exposed to competition from US imports. Rising interest rates on top of government measures to cool the housing market could weigh heavily on the housing industry. Companies exposed to these sectors face increased risk of non-payment. A trade credit insurance policy can help mitigate the risks of both slow payment and outright non-payment of accounts receivable.

Euler Hermes provides timely analyses on this and other subjects in our Weekly Export Risk Outlook (WERO), as well as monthly and quarterly analyses on the global macroeconomy and specific countries and industry sectors. Visit the Economic Research section of our website to learn more.

Most importantly, while the economy is strong at the moment, it is unlikely to grow much faster since it is right at potential growth, and the BoC is correctly raising rates to fend off inflation, and that’s one of the reasons we expect to see the economy grow more slowly in 2019.