More to do? Trudeau thinks so, and Team Poloz likely does, too
In July, Carolyn Wilkins, the Bank of Canada’s senior deputy governor, said that she, Governor Stephen Poloz and their three colleagues on the Governing Council would need to see some hard evidence that trade wars were hurting the Canadian economy before they’d cut interest rates.
There wasn’t much of it then, but there is now.
You won’t see the cracks by looking at the surface. Statistics Canada on Aug. 30 reported that gross domestic product expanded 0.9 per cent in the second quarter, the biggest quarter-to-quarter increase in two years, as the economy’s engines re-engaged after stalling last winter.
The spring rebound translates into an annualized growth rate of 3.7 per cent, considerably faster than the Bank of Canada’s July forecast of 2.3 per cent, and better than the two-per-cent rate that the United States recorded over the same period. Prime Minister Justin Trudeau was excited, tweeting, “When you trust in Canadians and invest in them, this is what we can achieve together: a strong and growing economy, over 1 million new jobs, and a better future for our kids & grandkids.”
Trudeau also admitted “we know there’s more to do.” That sentiment probably is closer to what Team Poloz will be feeling ahead of its next policy announcement on Sept. 4.
Trudeau could regret trumpeting the latest GDP number, because the economy likely won’t sustain that pace. The second-quarter surge was mostly the result of an outsized increase in exports. Oil prices recovered from last year’s collapse and shipments that were literally stuck, because of unusually terrible winter weather, finally made it to their destinations.
Those were one-time effects. The trade wars are choking global demand, and Canada’s exporters probably aren’t competitive enough to drive through the headwinds. The CPB Netherlands Bureau for Economic Policy Analysis’s index of global trade volumes, a closely watched indicator, dropped 0.3 per cent in the first quarter and declined another 0.7 per cent in the second quarter.
Exports won’t crumble, because most of our trade is with the U.S., one of the stronger large economies at present. But the U.S.’s big multinational companies are exposed to the rest of the world and it looks like they are starting to fade. The U.S. Federal Reserve earlier this month reported that industrial production declined 0.2 per cent in July, while noting that factory output had dropped more by than 1.5 per cent since the end of last year. Buoyant stock prices belie the lacklustre earnings growth.
“A meaningful third quarter acceleration seems unlikely,” Brian DePratto, a Toronto-Dominion Bank economist, told his clients in a note. “This suggests an economy struggling to operate near its potential,” he added, referring to the rate at which the economy can grow without triggering inflation, which the Bank of Canada estimates is currently about 1.8 per cent.
Real-estate investment grew for the first time in six quarters, the latest evidence that the housing lobby grossly exaggerated the threat posed by tighter mortgage rules. Instead, it appears authorities may have deflated various local housing bubbles and orchestrated a soft landing. Household disposable income and corporate earnings both posted solid gains, implying that there is little reason to worry about a recession in the foreseeable future. There’s a cushion.
This suggests an economy struggling to operate near its potential
But there is reason to be concerned about what lies beyond the horizon and whether the economy is ready to confront it.
Final domestic demand, which includes consumption, government spending, residential investment and business investment, declined in the second quarter, raising questions about the underlying strength of the rebound. Apart from housing, discretionary spending was weak. The household savings rate increased to 1.7 per cent from 1.3 per cent in the first quarter and 1.4 per cent at the end of 2018, suggesting consumers could be starting to worry about the record level of debt they’ve accumulated in recent years.
A bigger worry is business investment, which evaporated in the second quarter. Spending on machinery and equipment plunged 9.3 per cent after spiking by the same amount in the first quarter.
If households are tapped out after their years-long borrowing binge, economic growth will have to come from exports and business investment. But executives have little incentive to spend with the global outlook so unsettled.
There is reason to be concerned about what lies beyond the horizon and whether the economy is ready to confront it
Earlier this year, surveys indicated that businesses were keen to spend. Their retrenchment in the second quarter could mean the trade wars have caused them to rethink. If so, it would show that Canada is no different than countries such as Australia and South Korea, where central banks have cut interest rates this summer as economic indicators turned in the wrong direction.
The C.D. Howe Institute’s Monetary Policy Council of academic and Bay Street experts this week said the central bank should hold the line in September, but drop the benchmark rate by half a point to 1.25 per cent by March 2020, according to the median recommendation of the panel’s nine members.
If it’s so obvious the Bank of Canada must lower interest rates, then why wait? Sophia Drossos, a former economist at the Federal Reserve who now runs her own advisory firm in New York, has argued that if central banks know they are going to have to cut, they might as well go for it and take advantage of positive surprise effects.
Inflation is at the Bank of Canada’s target of two per cent, but Poloz has made it clear over the years that he would be unconcerned if prices increased a little faster than that for a period of time. The procession of central banks cutting interest rates this summer argues in favour of Canada taking out some insurance, too. That’s what the Bank of Canada did in 2015, when it cut interest rates to cushion the fall it anticipated would follow the sharp drop in oil prices. It turned out to be the right call.
Earlier this month, Bank of Nova Scotia’s economists replaced their forecast for interest-rate increases this year with a prediction of two quarter-point cuts by early 2020. They had assumed the trade wars would quiet, but now they see no end to the uncertainty as long as Donald Trump remains U.S. president.
Jean-François Perrault, the bank’s chief economist, on Aug. 15 said the first cut would come in October, although he acknowledged that the odds of a September move were “nearly 50/50.” He made that call before the GDP numbers were released. The possibility of a September surprise is higher now.