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Slower but above potential growth points to higher interest rates heading into 2018

John Clinkard
Slower but above potential growth points to higher interest rates heading into 2018

Based on the fact that the economy grew at a seasonally adjusted annual rate (SAAR) of 3.5% in the first quarter and by a barn-burning 4.5% in the second quarter, even if growth slows significantly in the second half (which we think it will) the Canadian economy should expand by 3.0% to 3.5% in 2017. This would be its strongest showing in more that 16 years and well ahead of the approximately 2% gain expected for the Group of Seven major developed countries excluding Canada.

The surge of growth in the first half was driven by three key components of aggregate demand. First, fuelled by the combination of an exceptionally strong gain of full-time employment, a 5% y/y increase in disposable incomes and persisting very low interest rates, consumer spending accelerated by over 4% (SAAR) compared to the second half of 2016.

The second key driver of growth in the first half was a rebound in non-farm inventory investment following a year-and-a-half of virtual stagnation. Third, despite being severely curtailed in the second quarter by Ontario’s Fair Housing Plan, residential construction also gave a significant boost to growth in the first half.

Our outlook for slower growth in the second half (noted above) is based on several forward-looking indicators of external and domestic economic activity. From an external perspective, although, as noted in the OECD’s recently released Interim Economic Outlook, the global economy appears to be exhibiting synchronized momentum, the near term outlook for the United States, the market for almost a quarter of Canada’s total GDP, is less upbeat.

According to the most recent (September) Markit U.S. Manufacturing PMI, operating conditions among U.S. manufacturing firms expanded in August at the slowest pace since June of 2016. This rather muted outlook is reinforced by the Conference Board’s Measure of CEO Confidence which, after reaching a post-recession high of 68 in the first quarter, declined by 7 points to 61 in the second quarter.

From a domestic perspective, the recent pattern of strong job growth in Canada should help to underpin consumer spending into 2018. However, the combination of the above-noted efforts to cool housing demand and a concomitant softening in consumer confidence indicated by the Conference Board in Canada, will likely dampen residential construction and contribute to a slowdown in house- related consumer spending through the remainder of this year and into the first half of 2018.

Following back-to-back gains in the first and second quarter, we expect that firms will scale back their inventory investment given that the ratio of manufacturing inventories-to-sales is the highest it has been since mid-2016.

The outlook for a more measured pace of growth over the near term is reinforced by two recently released economic indicators. First, after hitting a peak rate of increase of 0.8%, the Macdonald Laurier Institute’s forward-looking leading indicator has exhibited tepid growth of 0.2% or less in the last three months. Second, although small business optimism reflected by the Barometer of the Canadian Federation of Business is still in expansionary territory, the index has dropped steadily from a high of 66 in May to 56.9 in September, its lowest print since March of 2016.

Although there are signs that U.S. growth will moderate in the near term and lingering concerns about the eventual impact of a renegotiated North American Free Trade Agreement on Canadian exports, we expect the Canadian economy to continue to expand at or slightly above the Bank of Canada’s estimated range of potential growth of 1.0% to 1.6%, through the remainder of this year and well into 2018.

This prospect increases the likelihood that the Bank will further reduce the amount of monetary stimulus in the economy by raising its policy interest rate (currently at 1%) to at least 2% by the end of next year.

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