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Economic Developments and Prospects

Highlights

• Private sector forecasters expect Canadian real gross domestic product (GDP) to grow around 2 3⁄4 per cent in both 2006 and 2007. They expect nominal GDP in 2006 to be somewhat lower than they expected at the time of the May 2006 budget, primarily because of a lower forecast for GDP inflation.
• Real GDP growth moderated in the second quarter of 2006 after strong growth in the first quarter. Net exports have continued to be a drag on growth, but domestic demand growth has remained strong, supported by a healthy labour market.
• In the United States economic growth has slowed, primarily due to a sharp decline in housing activity and slower consumer spending.
• Despite slower growth in the U.S., the global expansion is projected to remain broadly on track, supported by strengthening activity in Europe, the ongoing recovery in Japan and continuing strong growth in emerging markets such as China.
• The risks to the Canadian economic outlook remain largely external.

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Introduction

This chapter reviews recent economic developments and prospects. It first discusses recent developments and the outlook for the U.S. and overseas economies, followed by a review of recent developments in the Canadian economy. It then describes the economic-planning assumptions that underlie the Government's budget plan and notes a number of risks and uncertainties associated with the private sector economic outlook.

U.S. and Overseas Economic Developments and Outlook

Recent U.S. Economic Developments

In 2005, U.S. real GDP grew 3.2 per cent. Real GDP growth slowed to 2.6 per cent in the second quarter of 2006, following strong growth of 5.6 per cent in the first quarter (Chart 1.1). The slowdown primarily reflected weaker growth in consumer spending as well as a large decline in residential investment. Advance National Accounts estimates show that third-quarter growth moderated to just 1.6 per cent due largely to a further contraction in residential investment, weaker net exports and a slower pace of inventory accumulation.

Recent data reveal a growing dichotomy within fixed investment. Non-residential investment remained healthy in the second quarter, growing 4.4 per cent. However, residential investment dropped over 10 per cent in the second quarter. According to advance estimates of the National Accounts, non-residential investment grew 8.6 per cent in the third quarter, while residential investment contracted by 17.4 per cent.

The correction in residential investment follows several years of rapid growth. Low interest rates and the development of attractive unconventional mortgage products, such as interest-only mortgages and non-prime lending, made housing more affordable, boosting housing demand and construction activity.

These factors led to a significant appreciation of house prices in the U.S. over the past few years (Chart 1.2). House prices grew rapidly and likely exceeded values warranted by fundamentals in many markets. Strong growth in house prices also fuelled expectations of continued rapid price gains, which in turn added a speculative component to housing demand. Soaring house prices boosted household wealth, allowing households to increase spending from current income as well as withdraw equity from their houses. This has translated into higher consumer spending and a lower personal savings rate.

The removal of monetary stimulus by the Federal Reserve since mid-2004 has led to a tightening of credit conditions and lowered the attractiveness of purchasing houses, thereby reducing demand and slowing house price appreciation. This in turn has reined in expectations of future house price inflation. A high past level of construction also led to an inventory overhang, putting additional downward pressure on housing prices and leading to an abrupt correction in housing starts.

The realignment of house prices to their fundamental values is negatively affecting wealth and likely played a role in the weakening in consumer expenditure growth in the second quarter. Partly offsetting this, however, has been a recent decline in gasoline prices, which frees up household income for other purchases.

U.S. Economic Outlook

Moderating domestic demand, driven by a cooling housing market, is expected to lower economic growth to below potential in the second half of 2006 and into 2007. However, solid wage growth and lower energy prices should support household expenditures. Strong business investment, reflecting an ongoing catch-up in non-residential structures spending from the protracted weakness that followed September 11th, should also help prevent a sharper slowdown of the U.S. economy. As well, strengthening growth abroad and the past depreciation of the U.S. dollar should support export growth.

For 2006 as a whole, private sector forecasters expect U.S. real GDP to increase 3.4 per cent, up from 3.2 per cent expected in March 2006 and unchanged from the April 2006 Blue Chip Economic Indicators forecast presented in the May 2006 budget (Chart 1.3). Private sector forecasters expect 2007 growth of 2.5 per cent, down from 2.8 per cent expected in March 2006. They expect 2008 growth to strengthen to 3.1 per cent.

Overseas Economies

Despite the expected slowdown in U.S. economic growth next year, the global expansion is projected to remain broadly on track, supported by solid economic activity in Europe, the ongoing recovery in Japan and continuing strong growth in emerging markets such as China. Overall, the International Monetary Fund (IMF) expects world real GDP growth (calculated at market exchange rates) to pick up from 3.4 per cent in 2005 to 3.8 per cent in 2006, before moderating to 3.5 per cent in 2007 (Chart 1.4).

In Japan, the recovery is now well established, with the economy growing in each of the past six quarters, supported by a solid expansion of domestic demand. The IMF expects the expansion to remain firmly on track, as strong profits and a rebound in bank credit bolster private investment, while consumer spending remains steady. Real GDP growth is expected to edge up to 2.7 per cent in 2006 before moderating to 2.1 per cent in 2007.

Economic activity remains strong in China, spurred on by a renewed pickup in investment and surging exports. Despite a series of measures to cool down the economy, the pace of expansion is expected to remain rapid at 10 per cent in both 2006 and 2007. There is potential for the economy to overheat, raising the risk of an investment boom-bust cycle. A sharper than expected U.S. slowdown would likely put downward pressure on exports and investment.

In the euro area, economic growth is strengthening, with growth increasingly driven by domestic demand, in particular business investment. The IMF expects business investment to continue to support economic activity in the second half of this year, with economic growth for 2006 projected to be 2.4 per cent, up from 1.3 per cent in 2005. Growth is expected to moderate to 2.0 per cent in 2007, largely reflecting a slower pace of consumer spending in Germany due to planned tax increases.

Growth has been solid in the United Kingdom over the first half of the year, as healthy employment gains have supported consumer spending, and investment has remained strong. Economic activity is expected to remain solid in the near term, with real GDP growth of 2.7 per cent in both 2006 and 2007.

Commodity Prices

Prices for key Canadian commodities have remained volatile in recent months. Crude oil and industrial metals prices remain at historically elevated levels despite recent declines, reflecting ongoing strong global demand growth and tight supply conditions. At the same time, higher inventory levels have resulted in sharply lower prices for natural gas, while lumber prices have dropped significantly in response to slowing U.S. housing demand.

Crude oil prices rose from US$72 per barrel at the time of the May 2006 budget to daily highs of close to US$77 in mid-summer, before dropping to under US$60 in recent weeks. The recent decline reflects easing geopolitical tensions, higher inventory levels and expectations of increased production capacity. However, despite a slowing U.S. economy, global oil demand is expected to remain strong, led by continued solid growth in China. Moreover, the risk of further geopolitical disruptions remains. As a result, private sector forecasters expect only a modest decline in oil prices from 2005 levels over the medium term.

After adjusting for inflation, this would leave crude oil prices close to record highs reached in the late 1970s over the near term, and well above their average over the last 35 years (Chart 1.5). However, industrialized economies are far less exposed to the negative impacts of higher oil prices than in the 1970s, using only approximately half as much oil, relative to GDP, as they did then.

Natural gas prices fell sharply over the past year, as a warmer than normal winter and the absence of hurricane-related disruptions pushed inventory levels well above recent historical averages. Private sector forecasters expect prices to rebound moderately over the near term, however, reflecting growing substitution away from relatively more expensive oil for home heating and electricity generation. While forecasters expect prices to remain below the record levels seen in 2005, they expect prices to remain significantly above their historical average.

Lumber prices, which have fallen by more than one-third since early 2005, are expected to remain at or below current levels over the near term, reflecting ongoing weakness in U.S. housing demand (Chart 1.6). Industrial metals prices are expected to moderate from current record highs but remain above historical trend levels, fuelled by continued strong demand from China.

Canadian Economic Developments

Canadian real GDP growth softened to 2.0 per cent in the second quarter of 2006 from 3.6 per cent in the first quarter and 2.9 per cent in 2005, as net exports weakened significantly. Growth in final domestic demand also moderated but remained solid in the second quarter (Chart 1.7).

Net exports have been a drag on growth in every quarter over the past year. The strength of the Canadian dollar and a slowing U.S. economy in the second quarter led to a decline in exports in the first half of 2006. The strong dollar has also contributed to strong import growth by reducing the prices of foreign goods and services.

Solid growth in final domestic demand has been supported by a healthy labour market. In the first five months of 2006, employment rose at a solid pace, pushing the employment rate to a record high of 63.2 per cent in May and the unemployment rate to 6.1 per cent, the lowest level since December 1974. Employment then fell between June and August, before increasing at a healthy pace in September and October. The unemployment rate remained close to its over 31-year low at 6.2 per cent in October.

So far in 2006, the Canadian economy has created over 260,000 new jobs, almost all of which are full-time. All regions of the country have benefited from the gain, with western Canada experiencing the strongest growth. In Ontario and Quebec, losses in manufacturing employment that are in part due to the stronger Canadian dollar have been more than offset by widespread gains in the services sector (Chart 1.8).

The high rate of job creation, combined with recent tax cuts, has contributed to strong income growth, which in turn has supported consumer spending. Consumer spending rose a solid 4.2 per cent in the second quarter of 2006 following growth of 5.1 per cent in the first quarter (Chart 1.9). In particular, spending on durable and semi-durable goods continued to grow strongly in the second quarter after surging in the first.

Growth in business non-residential investment has also remained solid, despite some moderation from the double-digit increases seen during most of 2005. Real investment in machinery and equipment (M&E) rose 8.8 per cent in both the first and second quarters of 2006, while real investment in non-residential structures increased 5.5 per cent in the second quarter following growth of 8.2 per cent in the first (Chart 1.10). The continuing strength in investment partly reflects the appreciation of the Canadian dollar, which has lowered the costs of imported M&E. As well, strong profit growth has boosted investment, particularly in the oil and gas sector, which accounts for about a quarter of total non-residential investment in Canada. In the second quarter of 2006, corporate profits stood at 13.7 per cent of GDP, near the record high of 14.3 per cent reached in the fourth quarter of 2005 (Chart 1.10).

Strong corporate profits have been supported by significant improvements in Canada's export prices. Continued increases in world demand have driven up the prices of Canadian-produced commodities, which, combined with ongoing adjustments to global current account imbalances, has led the Canadian dollar to appreciate since the beginning of 2003 (Chart 1.11).

Rising prices of commodity exports, particularly oil, have led to strong growth in commodity-producing provinces, especially Alberta. Wages in Alberta have jumped in response to a tight labour market in the province, with average hourly wages of employees in October 5.6 per cent higher than a year earlier, compared with growth of 3.1 per cent for all of Canada over the same period.

An influx of workers from other parts of the country has resulted in strong demand for housing in Alberta, causing house prices to soar. Prices of resale housing in Alberta were 39 per cent higher in September than a year earlier-more than four times the increase for Canada as a whole. While the housing market remains very active in British Columbia and Alberta, growth in house prices has moderated in most other regions of the country.

As a result of strong increases in house prices as well as in the prices of many services, Alberta accounted for more than one-quarter of core Consumer Price Index (CPI) inflation in Canada in September. Core CPI inflation in Canada had remained at or below 2 per cent since the beginning of 2004 before rising to 2.3 per cent in September. However, core CPI inflation excluding Alberta has continued to be below 2 per cent (Chart 1.12).

In September, total CPI inflation eased to 0.7 per cent, the slowest rate since March 2004. Lower inflation in September mainly reflected a fall in gasoline prices. The 1-percentage-point reduction in the goods and services tax rate has also helped to reduce total CPI inflation since July.

The Bank of Canada left its key policy rate unchanged in its July, September and October fixed action dates after seven consecutive 25-basis-point increases over nine months. The Bank expects that the small amount of excess demand currently in the economy will unwind over the coming months, with core CPI inflation returning to 2 per cent by the middle of 2007.

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 economic forecasts reported here reflect the survey conducted by the Department following the release of the second-quarter National Income and Expenditure Accounts by Statistics Canada on August 31. A total of 15 forecasters responded to the latest survey. Their responses form the basis for economic assumptions that underlie the five-year status quo fiscal projections reported in the next chapter.

Short-Term Outlook

Chart 1.13 provides a summary of the forecasts of real and nominal GDP growth for the period 2006 to 2008. The key change to the outlook since the May 2006 budget is that private sector forecasters expect nominal GDP growth to be weaker in 2006, primarily as a result of weaker GDP inflation.

Private sector forecasters expect real GDP to grow by 2.8 per cent in 2006, down slightly from 3.0 per cent anticipated at the time of the 2006 budget (Chart 1.13). Growth is expected to slow modestly to 2.7 per cent in 2007, identical to the budget forecast. The forecasts of real GDP growth in 2007 range from 2.3 per cent to 3.1 per cent, reflecting differing views regarding the U.S. outlook. In 2008, growth is expected to pick up to 3.0 per cent, slightly stronger than the 2.9 per cent anticipated at the time of the budget. According to the IMF, Canada is expected to have the second fastest growth rate in 2006 among Group of Seven (G7) countries, second only to the United States. For 2007, the IMF expects Canada to be the fastest-growing economy among the G7.

Private sector forecasters have lowered their forecast for GDP inflation in 2006 from 2.9 per cent to 2.1 per cent, reflecting lower than expected energy prices in the first half of the year (Table 1.1). For 2007, forecasters expect GDP inflation of 1.9 per cent, slightly higher than anticipated at the time of the budget. Private sector forecasts for GDP inflation in 2007 range from 0.9 per cent to 2.8 per cent. Forecasters expect GDP inflation of 1.9 per cent in 2008.

As a result, nominal GDP is projected to grow 5.0 per cent this year and 4.6 per cent in 2007, compared to 6.0 per cent and 4.6 per cent, respectively, in the budget forecast (Chart 1.13). Private sector forecasts of nominal GDP growth range from 3.2 per cent to 5.9 per cent in 2007. For 2008, nominal GDP growth of 4.9 per cent is projected, higher than the 4.6 per cent anticipated at the time of the budget.

Based on private sector forecasts, the level of nominal GDP in 2006 is projected to be about $13.5 billion lower than expected at the time of the 2006 budget, after adjusting for historical revisions. The level of nominal GDP is projected to be approximately $14.2 billion lower in 2007 and $10.2 billion lower in 2008 than expected at the time of the budget.

Short-term interest rates are projected to average 4.1 per cent in 2006, slightly higher than the 4.0 per cent in the budget forecast. Forecasters expect that short-term rates will average 3.9 per cent in 2007 and 4.2 per cent in 2008, both slightly lower than expected at the time of the 2006 budget.

Private sector forecasters expect Canadian long-term interest rates to average 4.3 per cent in 2006 and 2007-about 15 basis points lower, on average, over this period than forecast in the budget. For 2008, private sector forecasters expect long-term interest rates to average 4.6 per cent, 50 basis points lower than expected at the time of the budget.

Private sector forecasters expect the Canadian labour market to remain healthy. The unemployment rate is forecast to average 6.4 per cent in 2006 and 6.5 per cent in both 2007 and 2008, slightly lower than anticipated at the time of the budget. Forecasters have raised their outlook for employment growth in 2006 from 1.5 per cent in the budget to 1.8 per cent. Employment growth is expected to slow somewhat from this strong pace to 1.2 per cent in 2007 and 2008.

Medium-Term Outlook

Private sector forecasters have not significantly revised their medium-term economic outlook for 2009 to 2011 since the budget survey. Real GDP growth is expected to average 3.0 per cent over 2009 to 2011. Forecasters expect GDP inflation to average 1.7 per cent over the period, leaving average annual growth in nominal GDP unchanged at 4.7 per cent. Short-term and long-term interest rates are expected to rise very gradually from their 2006 levels to 4.4 per cent and 5.1 per cent, respectively, by 2011. The unemployment rate is expected to average 6.4 per cent over 2009 to 2011 and employment growth is forecast to average 1.2 per cent over the period.

Table 1.1
Private Sector Forecasts for 2006-2011

	2006	2007	2008	Average 2009-2011
	(per cent, unless otherwise indicated)
Real GDP growth
May 2006 budget	3.0	2.7	2.9	2.9
November 2006 Economic and Fiscal Update	2.8	2.7	3.0	3.0
GDP inflation
May 2006 budget	2.9	1.8	1.6	1.8
November 2006 Economic and Fiscal Update	2.1	1.9	1.9	1.7
Nominal GDP growth
May 2006 budget	6.0	4.6	4.6	4.7
November 2006 Economic and Fiscal Update	5.0	4.6	4.9	4.7
Nominal GDP level (billions of dollars)
May 2006 budget1	1,454	1,520	1,590	n/a
November 2006 Economic and Fiscal Update	1,440	1,506	1,580	n/a
3-month treasury bill rate
May 2006 budget	4.0	4.1	4.3	4.4
November 2006 Economic and Fiscal Update	4.1	3.9	4.2	4.3
10-year government bond rate
May 2006 budget	4.4	4.5	5.1	5.2
November 2006 Economic and Fiscal Update	4.3	4.3	4.6	5.0
Unemployment rate
May 2006 budget	6.6	6.6	6.7	6.5
November 2006 Economic and Fiscal Update	6.4	6.5	6.5	6.4
Employment growth
May 2006 budget	1.5	1.2	1.4	1.2
November 2006 Economic and Fiscal Update	1.8	1.2	1.2	1.2
U.S. real GDP growth
March 2006 survey of private sector forecasters	3.2	2.8	3.1	3.1
November 2006 Economic and Fiscal Update	3.4	2.5	3.1	3.1
Addendum
U.S. real GDP growth
May 2006 budget (April 2006 Blue Chip     Economic Indicators)	3.4	3.0	n/a	n/a
October 2006 Blue Chip Economic Indicators	3.4	2.6	3.1	3.0
1Nominal GDP levels have been adjusted to reflect May 2006 revisions to Canada's National Income and Expenditure Accounts. Sources: March 2006 and September 2006 Department of Finance surveys of private sector forecasters; April 2006 and October 2006 Blue Chip Economic Indicators.

Risks and Uncertainties

The main risks to the Canadian economic outlook continue to be external. Recent developments suggest that the correction in the U.S. housing market could be sharper than previously expected. There is also a risk of a significant drop in the prices of certain commodities, which are well above historical norms. As well, global imbalances remain large and continue to pose a medium-term risk to the outlook.

U.S. Housing Market

The private sector forecast for the U.S. economy is consistent with a significant further correction in the U.S. housing market. However, there is a risk that this correction could be greater than expected. A larger than expected house price correction would negatively affect consumer wealth and have negative implications for consumer demand. There is also a risk of a sharper than expected contraction in residential investment. Weaker than expected U.S. consumer spending and residential investment would have negative implications for Canadian growth.

Commodity Prices

Uncertainty over the future path of commodity prices remains a key risk to the outlook. Although the possibility of further price increases remains, the risk of greater than expected declines has risen recently. Indeed, the unexpected recent sharp decline in crude oil prices, the bulk of which occurred since the September Department of Finance survey of private sector forecasters, means that there is a risk that GDP inflation in the second half of 2006 could be below expectations. This would have negative implications for the level of nominal GDP for both 2006 and 2007.

Prices for several key commodities remain well above historical levels, in real terms, leading to the possibility of a significant correction in the near term. Real industrial metals prices are currently approximately 75 per cent above their average levels since the early 1970s, almost entirely due to strong demand from China. Similarly, real crude oil prices remain close to twice their average level over the same period, despite recent declines, in large measure due to strong growth in demand from China and the United States. Natural gas prices are also close to double their average over the period as a result of strong U.S. demand and higher oil prices.

A sharper than expected slowdown in U.S. growth, as well as a deceleration of growth in China from its current rapid pace, could cause commodity prices to fall more than anticipated, translating into lower than expected Canadian nominal GDP over the medium term.

Resolution of Global Imbalances

Global current account imbalances remain large (Chart 1.14). In 2005, the U.S. current account deficit grew to 6.4 per cent of U.S. GDP (almost 2 per cent of world GDP) and was matched by growing surpluses in China, oil-exporting countries and Germany. Current account surpluses remained large in Japan and the rest of emerging Asia as well.

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 21 per cent of GDP in 2005. The U.S. current account deficit must fall from its current high level if further substantial increases in net foreign debt are to be avoided.

Slowing growth in the U.S., strengthening growth in the euro area and solid growth in Japan will help to reduce imbalances, though the impact is likely to be small. Greater currency flexibility in emerging Asia and a reduction in the U.S. fiscal deficit would also help to correct global imbalances. However, there is a risk that the main channel of adjustment could be a further depreciation of the U.S. dollar against floating currencies such as the Canadian dollar, and this would pose additional challenges to Canada's export sector.

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Note: This chapter incorporates data available up to November 3, 2006.

 

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