Economic growth is expected to slow in Canada, the U.S. and globally over the next two years as the stimulus provided by U.S. tax cuts recedes, the impact of higher North American interest rates hits and China’s economy slows as a result of the trade war with the U.S.
Some slowdown is needed at this point in the economic cycle. Both the U.S. and Canada are operating at full capacity and there are signs of supply constraints developing. Unless growth slows, inflationary pressures will force the U.S. Federal Reserve Board and the Bank of Canada (BoC) to raise interest rates quickly. That would result in a major economic slowdown or even a recession.
The Fed and BoC are raising interest rates already and are expected to continue to do so. However, these increases are expected to be gradual, thus slowing real gross domestic product (GDP) growth by 2020 to 1.7% in Canada from this year’s estimated 2.1%-2.2%; and to around 2% in the U.S. from this year’s estimated 3%.
These growth rates sound low, but they’re around the potential growth rate for each country. Potential growth has slowed because there aren’t many new people entering the labour force as baby boomers retire.
Figuring out exactly when and by how much interest rates need to rise isn’t easy, and there’s a risk that the Fed won’t move quickly enough, says Paul Ferley, assistant chief economist at Royal Bank of Canada in Toronto: “[This has] happened before.”
Ferley’s concern is a potential buildup of “excess demand” in the U.S. that would push wages and prices upward. To ensure demand doesn’t get too strong, he believes, the Fed needs to increase interest rates by 25 basis points (bps) four times in 2019 – in addition to the two 25 bps interest rate hikes he anticipates during the rest of 2018. That would raise the Fed’s interest rate to 3.5% from 2% before the Fed’s meeting in late September.
Those increases are higher than many other economists forecast. Beata Caranci, vice president and chief economist with Toronto-Dominion Bank in Toronto, assumes the Fed will raise interest rates by 25 bps twice or three times in 2019, to 3% or 3.25%, respectively. Sébastien Lavoie, chief economist with Laurentian Bank of Canada in Montreal, anticipates two increases of 25 bps each (to 3%). Avery Shenfeld, managing director and chief economist with CIBC World Markets Inc. in Toronto, calls for just one 25 bps increase, to 2.75%.
The differences lie in how much and how quickly the economists expect higher interest rates to slow demand. For example, Shenfeld believes that just two increases in 2019 will slow U.S. economic growth to 1.4% in 2020, far lower than the 2% pace Caranci anticipates and the 2.1% Lavoie predicts. Shenfeld suggests the Fed would lower interest rates by 25 bps twice in 2020, given this low growth rate.
The BoC is likely to follow the Fed, although not necessarily on all of the interest rate increases, given that Canada’s economic growth isn’t as strong. The BoC’s overnight rate currently is 1.5%.
There’s a lot of momentum in the U.S., and business and consumer confidence are very strong. However, the strong economic growth that generated this sentiment can’t be maintained. There aren’t enough workers or production capacity to do so – and demand will soften as the stimulus from the tax cuts implemented earlier this year fades.
U.S. consumers certainly are spending on goods and services, but they aren’t rushing into the housing market. That’s a disappointment to financial markets and suggests caution on the part of consumers, says Caranci. One reason is increasing construction costs as a result of the steel, aluminum and softwood lumber tariffs. Another is more stringent mortgage requirements.
U.S. consumers also will face higher prices as the next round of tariffs on goods imported from China kicks in. U.S. President Donald Trump has proposed tariffs on US$200 million worth of goods from China. A 10% tarriff on these goods was expected imminently as Investment Executive went to press on Sept. 17.
The economists believe the inflation that will result due to these tariffs can be kept under control. However, Trump also threatens to put tariffs on another US$267 billion worth of goods from China – a move that could produce an inflation spiral that would force the Fed to raise interest rates sharply and result in a global recession.
Lavoie, Caranci and Craig Alexander, chief economist at Deloitte Canada in Toronto, consider further escalation of that trade war to be the biggest risk on the horizon for Canada.
That may sound surprising, but what happens to the U.S. and China affects everyone. Many countries, including Canada, would have to increase their interest rates to prevent large financial outflows. If the U.S. and China “continue to increase tariffs on each other’s goods, inflation will get out of hand and interest rates will go up sharply,” Lavoie says.
Fortunately, the odds of further escalation are low, says Shenfeld: “China can’t afford to escalate the trade war.” However, he warns, he doesn’t anticipate the situation will be cleared up quickly.
There’s less concern about the risk of tariffs on Canadian automobiles. Shenfeld says this measure wouldn’t cause a recession nationally, although Ontario would likely go into a downturn. Ferley agrees, saying that the tariffs probably would take 50 bps off Canada’s GDP growth and twice that much in Ontario.
The economists assume there will be a deal in place for a revised North American Free Trade Agreement and that there won’t be tariffs on automobiles as a result. Ferley says he’s encouraged because Trump has moderated his aggressive comments on Canada, which Ferley believes is due to pressure from senators and congressmen in U.S. states that do significant trade with Canada.
In the midst of all this, resources prices have held up well. Indeed, oil prices are higher than most economists anticipated a year ago. That’s partly because of strong U.S. growth, but also a result of geopolitical developments – particularly the return of U.S. sanctions on Iran. Metals prices also are reasonably healthy in general; they would take a hit, though, if the U.S.-China trade war escalates.
Important as resources prices are for Canada, there’s a worse potential problem following the judicially caused delay of the Trans Mountain Pipeline. Even if the pipeline gets built, foreign investors may become hesitant about investing in a country in which getting projects approved is so difficult.
“Issues need to be addressed to show that Canada has the ability to keep the regulatory process to reasonable timelines,” says Ferley.
This is doable, adds Alexander: “We need strong environmental standards, but if Canada can put a price on carbon and reduce emissions, that’s not inconsistent with having pipelines.”