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Chapter 2
Economic Developments and Prospects

Note: This chapter incorporates data available up to November 4, 2005.
Figures in this chapter are at annual rates unless otherwise noted.

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Highlights

• Canadian economic growth strengthened in 2004 and 2005 and has become more balanced as Canadian net exports have begun to recover, despite a significant appreciation of the Canadian dollar.
• The Canadian dollar has appreciated more against the U.S. dollar than any other major currency since the beginning of 2003, reflecting a generalized depreciation of the U.S. dollar and, more recently, significant increases in commodity prices.
• World oil prices have surged as world demand increased and spare oil capacity shrank. High oil prices and a warmer-than-normal summer have also pushed North American natural gas prices to record highs. Higher oil and natural gas prices have boosted profits and encouraged investment in the energy sector.
• Due in part to a robust job market and healthy incomes, consumer spending has been strong since the beginning of 2004.
• Private sector forecasters expect real gross domestic product (GDP) to grow by 2.8 per cent in 2005, down slightly from the 2.9 per cent expected at the time of the February 2005 budget. They expect growth to pick up to 2.9 per cent in 2006 and to 3.1 per cent in 2007.
• The outlook is generally positive, but there are a number of risks and uncertainties.
• While consumer spending has held up surprisingly well despite rapid increases in oil prices, there is a risk that sustained increases could affect consumer confidence and spending.
• The large and persistent U.S. current account deficit could result in a significant further depreciation of the U.S. dollar against all major currencies, including the Canadian dollar. This would pose additional challenges for Canada's export sector.
• The rapid increase in house prices since 2001 in the U.S. has helped support consumer spending growth. If price appreciation were to slow or stall, consumer demand would slow more than expected.

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World Economic Conditions

Global growth has moderated but remains solid

• Despite the dampening effects of higher energy prices, global economic expansion remains broadly on track. The International Monetary Fund (IMF) expects world real GDP growth to slow from its rapid pace of 5.1 per cent in 2004 to a still-strong 4.3 per cent in both 2005 and 2006. U.S. growth is also expected to moderate, but remains the highest among the Group of Seven (G7) countries over the near term.
• The Fund expects the recovery in Japan to become increasingly well entrenched, as business investment continues to grow at a healthy pace and a stronger labour market helps to support domestic demand. Real GDP growth in Japan is now expected to be 2.0 per cent in 2005 and 2006. The Chinese economy is expected to continue to expand at a rapid pace. The IMF expects Chinese real GDP to grow by 9.0 per cent in 2005 and 8.2 per cent in 2006.
• The momentum of the recovery in the Euro area faded somewhat in the first half of 2005 due to weak net exports and domestic demand, which in turn were a consequence of higher energy prices. Real GDP growth for the Euro area is expected to average only 1.2 per cent in 2005, rising to 1.8 per cent in 2006.

World oil prices have continued to rise.

• In 2005, world oil prices continued the upward trend that began in earnest in 2003. Strong demand growth and tight supply conditions have led to high prices and significant price volatility in response to recent supply disruptions, such as Hurricanes Katrina and Rita. The price of West Texas Intermediate crude oil reached a high of nearly US$70 per barrel in August, more than double the price in the fall of 2003. Since then, prices have moderated somewhat but remain elevated.
• Even after adjusting for inflation, oil prices are now nearing the record highs reached in the late 1970s. The doubling of prices witnessed over the past two years mirrors the price increases recorded in both the 1973 and 1979 oil price shocks. Nevertheless, the Canadian economy is much less exposed to increases in oil prices than it was in the 1970s. Relative to the level of GDP, we now use only about 50 per cent as much oil and gas as we did then.

.as demand for oil in emerging Asia continues to be robust

• However, in contrast with previous episodes, recent increases in oil prices largely reflect rapid growth in global demand for oil.
• Between 1994 and 2004, world oil demand growth averaged more than 1.2 million barrels per day. However, world demand increased by almost 2.5 million barrels per day in 2004, driven by an unprecedented increase in demand from China of about 1 million barrels per day-more than all the countries in the Organisation for Economic Co-operation and Development (OECD) combined.
• This sharp increase in demand from China and other Asian economies stems from their rapid economic growth, combined with an oil intensity (oil use relative to output) that is more than double that of developed countries.

In the U.S. the near-term economic outlook remains solid.

• After strong growth of 3.8 per cent in the first quarter of 2005, U.S. economic activity moderated somewhat in the second quarter to 3.3 per cent. The slower pace of growth mainly reflected a sharp pullback in the pace of inventory investment, which more than offset an improvement in the trade balance.
• Looking ahead, growth is expected to remain solid, although the gradual removal of monetary policy stimulus by the Federal Reserve means that growth will be somewhat lower than in 2004.
• However, rising incomes and healthy corporate profits should continue to support consumer spending and business investment and therefore will help to sustain growth in domestic demand in the face of higher energy prices. An expected depreciation of the U.S. dollar will also provide support to the U.S. export sector.
• Overall, private sector forecasters expect U.S. real GDP growth to average 3.5 per cent in 2005, down just 0.1 percentage point from expectations at the time of the February 2005 budget. Growth for 2006 is expected to average 3.3 per cent, down from 3.4 per cent at the time of the budget.

.as Hurricanes Katrina and Rita have had only a modest economic impact

• Oil and gas production in the Gulf of Mexico was severely disrupted when Hurricanes Katrina and Rita hit the Gulf Coast of the United States in August and September.
• Moreover, power outages and water damage to some refineries forced the complete shutdown of the majority of gasoline refineries situated in the affected areas following Hurricane Katrina. This pushed up U.S. wholesale and retail gasoline prices sharply in the immediate aftermath of the hurricane, and led to higher gasoline prices in Canada and other countries.
• The pressure on wholesale gasoline prices eased considerably in the following weeks, as it became clear that damage to refineries was limited and all but a few were able to resume production in a relatively short period of time.
• The production losses associated with the hurricanes and the dampening effect of higher gasoline prices on consumer spending have had a negative impact on the U.S. economy. However, the U.S. economy is bouncing back quickly as the negative impacts are being offset by reconstruction efforts.

Canadian Economic Developments

The Canadian economy has strengthened

• Real GDP grew 3.2 per cent in the second quarter of 2005, up from the 2.1-per-cent growth observed in each of the two previous quarters, as real net exports increased for the first time in four quarters. Final domestic demand grew a solid 2.9 per cent in the second quarter but slowed from a very strong 6.2-per-cent gain in the first quarter.
• In the second half of 2004 and early 2005, robust domestic demand accounted for all of Canada's output growth as healthy incomes, record profits and a robust job market led to strong growth in investment and consumer spending. However, strong import growth and declines in exports offset the strength in domestic demand.
• In the second quarter of 2005, however, both net exports and domestic demand contributed to growth as exporters regained ground. The gradual return of net exports to positive growth over the previous four quarters suggests that Canadian firms are adjusting to the challenges posed by the past appreciation of the dollar.

The labour market continues to be healthy.

• The Canadian labour market has strengthened since the economic slowdown in 2001. Since January 2002, the economy has created more than 1,221,000 jobs-the vast majority of which are full-time. With strong job creation in Canada, the unemployment rate has fallen steadily despite near-record rates of participation in the labour market, dipping to 6.6 per cent in October 2005, the lowest in 30 years.
• The employment rate reached a record high of 62.8 per cent in mid-2004 and has remained close to that level during the first half of 2005. Both the employment rate and the participation rate-once adjusted for differences in methodology with the U.S. data-remain higher in Canada than in the U.S.

.in all regions of the country

• All areas of the country have benefited from the recovery of the labour market following the 2001 slowdown. The recovery has been strongest in British Columbia, where employment has grown more than 11 per cent and unemployment has fallen by more than 3 percentage points. Employment in central Canada and the Prairies has grown more than 6 per cent, while unemployment has fallen. The unemployment rate has also fallen in the Atlantic provinces.

However, the manufacturing sector has been affected by the strong appreciation of the Canadian dollar

• The appreciation of the Canadian dollar since the end of 2002 has posed a challenge to Canadian firms that are highly exposed to international trade. Employment in the manufacturing sector fell by 144,600 from January 2003 to October 2005-a reduction of more than 6 per cent.
• Nevertheless, the overall economy has been adjusting well to the challenge posed by the rising dollar, with employment in all other industries growing by 856,700 during this period, indicating that more than enough new jobs are being created to offset the losses in the manufacturing sector.

Income growth has supported consumer spending

• The strong pace of job creation has supported income growth in all regions of the country, which in turn has supported strong consumption growth throughout 2004 and the beginning of 2005.
• In the second quarter of 2005, real personal disposable income per capita stood 0.8 per cent above its level a year earlier and over 16 per cent higher than its trough in the second quarter of 1996. Real net worth per capita stood about 30 per cent above its level in the second quarter of 1996.
• Historically low interest rates, combined with solid wealth and income growth, have supported an average real consumer spending increase of more than 4 per cent since the second quarter of 2004, with particularly strong durable goods consumption growth.

Strong income growth and low mortgage rates continue to support housing activity

• Rising disposable income due to healthy employment growth, combined with low interest rates, has improved housing affordability substantially since the late 1980s. Housing affordability remains near its best level on record.
• These factors continue to support robust residential investment growth, which averaged over 3 per cent in the first two quarters of 2005. Sales of existing houses have grown by nearly 50 per cent since the beginning of 2000. The level of housing starts reached an annualized average of 225,467 new units in the first nine months of 2005-just below the record level recorded in 2004 and well above its historical average.

Corporate profits have reached record levels

• Corporate profits in the second quarter of 2005 were more than 5 per cent above their level one year earlier. They now stand at 14.0 per cent of GDP, the highest level in over 30 years.
• Profit increases have been concentrated in the oil and gas sector-which has benefited from higher prices and strong international demand. Profits are also up strongly since last year outside the oil and gas sector and now stand well above historical averages.
• Manufacturing sector profits have been negatively affected by the rapid appreciation of the Canadian dollar and rising energy costs. Retail sector profits, on the other hand, have benefited from the appreciation of the dollar, as the cost of imported goods has fallen.

The Canadian dollar has continued to rise against the U.S. dollar

• In 2003-2004, the Canadian dollar appreciated significantly against the U.S. dollar, as was the case with other major currencies since 2002. This appreciation was driven in large part by global portfolio adjustments in response to persistent U.S. current account imbalances.
• However, the Canadian dollar was one of the few major currencies to also appreciate against the U.S. dollar in 2005. This suggests that the more recent appreciation in Canada has been driven by factors not shared by many other countries.
• Higher prices for oil and natural gas tend to push up the value of the Canadian dollar, as Canada is a significant net exporter of these commodities. Canada's trade surplus in oil and gas represents more than 2.5 per cent of GDP. Surging prices for oil and natural gas helped push the Canadian dollar to a 14-year high in September 2005.

The Canadian economy is more exposed to U.S.-dollar fluctuations

• Total trade-in particular exports to the U.S.-represents a higher proportion of GDP in Canada than in other major countries. Therefore, the depreciation of the U.S. dollar has been a more significant economic development for Canada than for other major economies.
• Canada has borne much of the brunt of global adjustment.
• Once adjusted for differences in trade flows across countries, the Canadian dollar has appreciated much more than other currencies in every year since the end of 2002.

Surging energy prices and the rising Canadian dollar have helped boost business investment by over 8 per cent over the past year

• Higher energy prices have stimulated engineering construction in the oil and gas sector, which in turn has contributed to a strengthening in non-residential construction. As a result, investment in the oil and gas sector is near its highest level, relative to GDP, in 15 years.
• Real investment in machinery and equipment (M&E) was 11.1 per cent higher in the second quarter of 2005 than one year earlier, thanks in part to the stronger Canadian dollar-which has made imported M&E more affordable-and high levels of capacity utilization. Investment in information, telecommunications and computer equipment has been especially strong since the end of 2003.

Core inflation has remained low in spite of sharp increases in energy prices

• While total inflation has increased somewhat following recent surges in energy prices, core inflation has remained low and stable.
• The credibility of the Bank of Canada's monetary policy, combined with Canada's strong fiscal record, has resulted in inflation expectations that are well anchored to the 2-per-cent target. Therefore a significant increase in energy prices should now have little effect on the inflation of other goods and services.

Private Sector Economic Forecasts

• The Department of Finance surveys private sector economic forecasters on a quarterly basis regarding their outlook for the Canadian economy. The Minister of Finance, along with departmental officials, also meets with a group of private sector economists to discuss risks and uncertainties associated with the economic outlook.
• The economic forecasts reported here reflect the survey of private sector forecasters conducted by the Department following the release of the second-quarter National Accounts by Statistics Canada on August 31. A total of 16 forecasters have responded to the latest survey. Their responses form the basis for economic assumptions that underlie the five-year status quo fiscal projections.

The Canadian Economic Outlook

Private sector forecasters expect growth in Canada to pick up gradually

• Private sector forecasters expect real GDP to grow by 2.8 per cent in 2005, down slightly from the 2.9 per cent expected at the time of the February 2005 budget. Growth is expected to pick up to 2.9 per cent in 2006, modestly lower than the 3.1 per cent forecast at the time of the 2005 budget. In 2007, growth is expected to equal the 3.1 per cent anticipated in the 2005 budget. According to the IMF, Canada is expected to have the second fastest growth rate in 2005 and 2006 among G7 countries, second only to the United States.
• Private sector forecasters have raised their forecast for GDP inflation in 2005 and 2006, reflecting stronger-than-expected growth in energy prices. In 2007, however, GDP inflation is expected to be lower than forecast in the 2005 budget due to expected near-term declines in commodity prices. As a result, nominal GDP is projected to grow 5.3 per cent this year and 5.2 per cent in 2006, compared to 4.9 per cent and 5.0 per cent, respectively, at the time of the 2005 budget. Private sector forecasters expect 4.7 per cent growth in 2007, compared to 5.0 per cent expected at the time of the budget.

The near-term outlook for nominal GDP is higher than at the time of the February 2005 budget

• Based on private sector forecasts, the level of nominal GDP in 2005 is projected to be about $4.7 billion higher, after adjusting for historical revisions, than expected at the time of the February 2005 budget. The level of nominal GDP is projected to be approximately $6.9 billion higher in 2006 and $3.5 billion higher in 2007 than expected at the time of the 2005 budget, after adjusting for historical revisions.

Forecasters expect monetary stimulus to be withdrawn gradually

• Private sector forecasters expect the Bank of Canada to gradually raise its target interest rate through 2006 and 2007, but at a slightly slower pace than anticipated at the time of the February 2005 budget. Short-term interest rates are projected to average 2.7 per cent in 2005, unchanged from the budget forecast. Forecasters expect that short-term rates will average 3.4 per cent in 2006 and 4.1 per cent in 2007, both slightly lower than expected at the time of the 2005 budget.
• The outlook for long-term interest rates has been lowered significantly, due in part to downward revisions to the outlook for long-term U.S. interest rates, and in part to a more gradual expected withdrawal of monetary stimulus. Private sector forecasters expect long-term interest rates in Canada to average 4.0 per cent in 2005, 4.4 per cent in 2006 and 5.1 in 2007-about 60 basis points lower on average over this period than anticipated at the time of the 2005 budget.

Private Sector Survey Forecasts for 2005-2010

	2005	2006	2007	Average  2008-2010
	(per cent)
Real GDP growth
February 2005 budget	2.9	3.1	3.1	2.8
November 2005 Economic and Fiscal Update	2.8	2.9	3.1	2.9
GDP inflation
February 2005 budget	2.0	1.9	1.8	1.9
November 2005 Economic and Fiscal Update	2.4	2.2	1.6	1.7
Nominal GDP growth
February 2005 budget	4.9	5.0	5.0	4.7
November 2005 Economic and Fiscal Update	5.3	5.2	4.7	4.7
3-month treasury bill rate
February 2005 budget	2.7	3.5	4.5	4.6
November 2005 Economic and Fiscal Update	2.7	3.4	4.1	4.2
10-year government bond rate
February 2005 budget	4.6	5.1	5.5	5.6
November 2005 Economic and Fiscal Update	4.0	4.4	5.1	5.4
Employment growth
February 2005 budget	1.4	1.5	1.5	1.2
November 2005 Economic and Fiscal Update	1.3	1.3	1.4	1.2
Addendum:
U.S. real GDP growth
February 2005 budget	3.6	3.4	n/a	n/a
November 2005Economic and Fiscal Update	3.5	3.3	n/a	n/a
Sources: December 2004 and September 2005 Department of Finance surveys of private sector forecasters. U.S. real GDP growth: January 2005 and October 2005 Blue Chip Economic Indicators.

Risks and Uncertainties

Overview

The economic outlook is based on the average private sector forecast of key economic variables, which comprises a range of individual forecasts. The range in the September survey of private sector forecasters is similar over the forecast horizon to the range of forecasts of real GDP growth underlying the economic outlook presented in Budget 2005.

However, private sector economists have noted a number of risks to the Canadian outlook. These risks are largely external, relating to the volatility of oil prices as well as sustained global current account imbalances and the rapid increase in U.S. house prices.

Energy Prices

Oil production capacity remains limited, leaving the market vulnerable to shocks.

• Rapid growth in the demand for oil used up much of the world's spare crude oil production capacity in 2003 and 2004. Continued strong growth in oil demand, combined with limited spare production capacity, implies a tight oil market over the near term. As a result, oil prices are likely to remain high, and supply disruptions and other shocks could lead to further oil price spikes.
• Natural gas prices tend to vary considerably from month to month. Rapid increases in oil prices, combined with higher-than-normal energy demand due to an unseasonably hot summer in North America and supply disruptions due to Hurricanes Katrina and Rita, have pushed up natural gas prices recently. In both nominal and real terms, natural gas prices are higher than in the 1970s and 1980s.

.which could affect consumer confidence

• U.S. and Canadian real consumer expenditure growth has remained remarkably robust in the face of rising energy prices. However, consumer confidence dipped noticeably in both Canada and the U.S. in September, possibly reflecting the impact of higher oil and gasoline prices.
• Consumer confidence could be affected further if oil prices continue to rise, leading to slower consumer spending and therefore weaker economic growth.

Global Imbalances/Canadian Dollar

Global imbalances have worsened, reflecting increased capital inflows to the U.S., which have pushed long-term interest rates to low levels

• The U.S. current account deficit averaged a record 6.4 per cent of GDP in the first half of 2005, up from 5.7 per cent in 2004. This deterioration has been part of a general widening of global imbalances since 1996, as Asia and oil exporters have run increasingly large current account surpluses.
• These imbalances partly reflect expansionary U.S. fiscal policy, which has led to increased U.S. demand for foreign savings in order to finance investment. However, there has also been an increased demand by foreign countries for U.S. assets, reflecting the continuation of export-oriented Asian growth, foreign exchange intervention by Asian central banks, depressed investment opportunities in industrialized countries outside the U.S., and increased saving in major oil exporters. This increase in foreign demand for U.S. assets has led to reductions in U.S. long-term interest rates towards historic lows, despite recent increases in short-term interest rates.

The recent depreciation of the U.S. dollar has been significantly less than in the mid-1980s, when the current account deficit was smaller.

• Although the U.S. has thus far been able to finance its current account deficit, it is unlikely that deficits of this magnitude can be maintained indefinitely. Sustained large U.S. current account deficits have meant that U.S. net foreign indebtedness has steadily risen, reaching 25 per cent of GDP in 2004. The U.S. current account deficit must fall from its current high level if further substantial increases in net foreign debt as a share of GDP are to be avoided.
• One potential way for the U.S. current account deficit to be corrected would be through a significant depreciation of the U.S. dollar and, indeed, the trade-weighted value of the U.S. dollar has depreciated by about 12 per cent since 2002. However, this depreciation has mostly occurred against floating currencies like the euro and the Canadian dollar rather than against the currencies of those Asian countries that contributed most to the recent rise in the U.S. current account deficit. Furthermore, the depreciation has thus far been significantly less than observed in the mid-1980s. The U.S. dollar depreciated by more than 25 per cent between 1985 and 1988, even though the U.S. current account deficit was significantly smaller than it is now, implying that a further correction is possible.

.and without stronger overseas growth, a further U.S.-dollar depreciation will be needed to significantly reduce the U.S. current account deficit

• The other key feature of the current account adjustment in the late 1980s was stronger growth of the U.S. trading partners than the U.S. itself. This meant that demand for U.S. exports was growing faster than U.S. demand for foreign imports, which, along with the significant depreciation of the U.S. dollar, helped bring the U.S. current account back into balance.
• However in recent years, growth of U.S. trading partners has been weaker than in the U.S. Without stronger growth outside the U.S., a larger depreciation of the U.S. dollar than in the 1980s will be needed to achieve a significant reduction in the U.S. current account. This implies a risk that the Canadian dollar might appreciate still further against the U.S. dollar. Furthermore, if Asian central banks were to suddenly reduce purchases of U.S. treasuries, this could lead to a sharp and potentially destabilizing fall in the U.S. dollar, together with significant increases in U.S. long-term interest rates.

House Prices

U.S. house prices have risen significantly-more than in Canada but much less than in the United Kingdom and Australia

• House prices in the U.S. have increased at a rapid rate in the past few years. U.S. resale house prices are now about 70 per cent higher than in 1998. In some local markets, the increase has been even greater: prices of existing houses have increased by more than 140 per cent in Los Angeles and by about 125 per cent in Boston.
• Although not as dramatic as in the U.S., the average resale price of an existing house in Canada has increased by more than 60 per cent since 1998, with growth of more than 90 per cent in Ottawa-Carleton and Montréal.
• Despite these rapid increases, house price appreciation in the U.S. and Canada is well below that of many other countries. For example, house prices have increased by more than 130 per cent in the United Kingdom over the same period.

A slowdown in house prices could lead to weaker consumption growth, particularly in the U.S.

• The strength of housing markets in both the United Kingdom and the United States has helped to support consumer spending. Households' willingness and ability to spend accumulated housing wealth-through equity withdrawals and mortgage refinancing-has been a major contributor to the growth in consumer expenditures.
• Consumer spending growth in the United Kingdom weakened significantly following the slowdown in housing prices, suggesting that consumer spending could be vulnerable to reduced growth in house prices.
• If the growth of U.S. house prices were to slow precipitously, U.S. consumer spending growth could slow as well, as the support to spending from rapid gains in housing wealth is diminished.

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