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Update of Economic and Fiscal Projections: part 2 of 3

Chapter 2 
Economic Developments and Prospects

Introduction 

The global economic environment remains highly uncertain. The key challenge currently facing the global recovery remains the euro area sovereign debt and banking crisis, which has triggered ongoing volatility in financial markets, weighed on consumer and business confidence and resulted in a deterioration of the global outlook. In the United States, the recovery remains fragile and the U.S. economy faces the further risk of significant federal government fiscal contraction at the beginning of next year (the so-called “fiscal cliff”), which could push it back into recession. Moreover, unless U.S. policy makers develop a credible medium-term plan to put that country’s debt on a sustainable path, this could lead to rising uncertainty and ultimately slower economic growth.

Despite this challenging global economic environment, the Canadian economy continues to expand, albeit at a modest pace, enjoying one of the best performances among Group of Seven (G-7) countries over the recovery. However, Canada is not immune to these external developments. While the private sector forecast for real gross domestic product (GDP) growth is largely unchanged since Budget 2012, weaker global commodity prices during the first half of this year have reduced the outlook for GDP inflation in 2012. This has reduced the expected level of nominal GDP in 2012 and over the 2012 to 2016 period. Chapter 3 reviews the implications of this reduction in the expected level of nominal GDP for the fiscal outlook.

This chapter reviews major global and Canadian economic developments since Budget 2012, presents the private sector economic forecast that forms the basis for the fiscal projections, and discusses the risks and uncertainties surrounding this economic forecast.

Global Economic Developments and Outlook 

The global economy has shown signs of renewed weakness since Budget 2012. Financial market stress and sovereign debt concerns in the euro area have reintensified, while global indicators of business activity have generally softened, pointing to sluggish world economic growth in mid-2012. Global growth forecasts from the International Monetary Fund (IMF) and other organizations have been revised down. In response to these developments, many central banks have eased monetary conditions, either by cutting policy rates (e.g. in the euro area, China, Brazil and Australia, among others) or through asset purchases aimed at lowering long-term market interest rates (e.g. in the U.S., Japan and the United Kingdom).

In Europe, the sovereign debt and banking crisis in the euro area continues, and the uncertainty and volatility related to the crisis has weighed on economic activity. Indicators of business conditions from July through September have remained negative, suggesting that the euro area economy contracted again in the third quarter of 2012 (official statistics for the third quarter will be released on November 15^th). As a result, the euro area economy is now most likely in recession (Chart 2.1).

While concerns remain with respect to the situations in Greece, Ireland and Portugal, the focus is now on the larger economies of Spain—which is grappling with a sharp recession and a fragile banking sector—and Italy—which is falling deeper into recession and experiencing challenges in implementing the government’s structural reform program. In response to the weakness in the euro area, the European Central Bank (ECB) lowered its policy rate to a euro-era low of 0.75 per cent in early July. In September, the ECB announced the details of a new bond-buying plan, dubbed “Outright Monetary Transactions”, through which it will purchase the sovereign bonds of stressed euro area countries that have committed to structural reforms under a European support program. European leaders have also made progress on commitments to strengthen the European Monetary Union through deeper economic and financial integration. Despite these actions, market stress remains elevated. Looking ahead—and assuming the sovereign debt and banking crisis remains contained—the IMF expects the euro area to return to very modest growth in early 2013.

In the United States, the economic recovery continues at a modest pace. Since the start of the current recovery, U.S. real GDP has grown at its weakest pace relative to any other recovery since World War II, with the output lost during the recession having only recently been recouped (Chart 2.2). The weak pace of growth, which is typical of recoveries following financial crises, has been due primarily to significant wealth losses among households and their efforts to increase savings and reduce debt levels. This has been reinforced by sustained weakness in U.S. employment, which remains well below pre-recession levels. Significant slack in the housing sector also continues to restrain growth in the U.S., although there has been a modest but encouraging pickup in activity over the last few months. More recently, spillovers from the euro area sovereign debt and banking crisis have also weighed on U.S. growth, both directly through lower exports and indirectly through the negative impacts of the crisis on financial markets and confidence. As well, Hurricane Sandy caused major disruptions along the mid-Atlantic U.S. coast in late October and early November, although the impact of the storm on near-term U.S. growth is expected to be very modest.

In response to ongoing economic weakness and an elevated unemployment rate, the Federal Reserve has taken further steps to ease monetary policy, indicating that it now expects “exceptionally low levels for the federal funds rate” to run “at least through mid-2015”, while also announcing its intention to purchase a further US$40 billion in securities per month for the foreseeable future (“QE3”). Moreover, it has signalled that it will continue these purchases, undertake additional asset purchases, or employ other policy tools, until the labour market improves substantially, while also fulfilling its other key policy mandate of maintaining stable prices. All in all, U.S. economic growth is expected to remain modest going forward, constrained by the ongoing reduction in household debt levels and spillovers from the euro area sovereign debt and banking crisis, as well as necessary fiscal restraint.

Indeed, fiscal policy is one of the largest downside risks to U.S. growth next year and in the medium term. A number of tax increases and spending reduction measures—representing about 4  per cent of U.S. GDP—are scheduled to come into force automatically at the beginning of 2013 (the so-called “fiscal cliff”). Absent a political agreement to help smooth out this fiscal adjustment, a fiscal contraction of this magnitude could tip the U.S. economy back into recession. Private sector economists are generally assuming that the full implementation of all budgeted tax and spending measures will be avoided through some form of political compromise. Nonetheless, they have downgraded their expectations for near-term U.S. real GDP growth and now expect growth of 2.2 per cent in 2012 and 2.0  per cent in 2013 (Chart 2.3).

In addition, the U.S. federal government will again reach its legislated debt ceiling sometime in February or March 2013, raising the risk of a repeat of the debt ceiling crisis of the summer of 2011, when political delays in raising the ceiling resulted in financial market turmoil, declines in confidence and a downgrade to the U.S. sovereign credit rating by one rating agency. Beyond the near term, the fiscal risk in the U.S. relates to insufficient progress made in developing a credible medium-term plan to put the federal debt burden on a sustainable path. In the absence of policy action, the already-high federal debt-to-GDP ratio will continue to rise. Over the medium term, this could lead to a rise in uncertainty and a fall in confidence, inducing households and businesses to reduce spending and investment. This would harm the U.S. economy and weigh on the global economic recovery.

In emerging and developing economies, the pace of economic activity has also eased but remains strong compared to the advanced economies. In China, the pace of economic growth slowed in late 2011 and early 2012 to its weakest pace since the global recession, reflecting the effects of past policy tightening undertaken to cool the economy after signs of overheating surfaced in 2010, as well as weaker foreign demand for Chinese exports, particularly from Europe. In response to the slowdown in growth, as well as a decline in inflation, the Chinese government eased monetary policy in late 2011 and early 2012, and announced a modest fiscal stimulus plan in June 2012. While real GDP growth on a year-over-year basis continued to slow in the third quarter, quarter-over-quarter growth, which is more indicative of current economic momentum, has picked up recently, rising from 6.1 per cent in the first quarter of 2012 to 8.2 per cent in the second quarter and 9.1 per cent in the third quarter (Chart 2.4). Moreover, September data on industrial production, retail sales and exports point to continued momentum heading into the fourth quarter. Overall, the IMF expects economic growth in China to pick up slightly from 7.8 per cent in 2012 to 8.2 per cent 2013, as domestic demand growth, especially investment growth, continues to be supported by the policy easing now underway.

Reflecting recent global economic developments, the IMF has revised down its outlook for global growth for the second time in six months, to 3.3 per cent in 2012 and 3.6 per cent in 2013 (Chart 2.5). For advanced economies, the IMF now projects growth of only 1.3 per cent in 2012 and 1.5 per cent in 2013, reflecting weakness in the euro area and the modest pace of recovery in the United States. The modest pickup in global activity in 2013 projected by the IMF reflects recent policy easing by a number of central banks in both advanced and emerging economies. However, the IMF warns that its global outlook is predicated on the successful containment of the euro area sovereign debt and banking crisis and the avoidance of a sharp fiscal contraction in the United States.

The slowdown in growth in advanced economies, particularly in the U.S., has significant consequences for Canadian exports. In 2011, 74 per cent of Canada’s goods exports were destined for the U.S., down from 87 per cent a decade earlier. This decline has been mirrored by rising shares of our exports to Europe, emerging Asia, and other markets. With growth in the U.S. expected to remain modest going forward, it is clear that Canada will need to continue to develop other export markets, in regions such as Europe and Asia, to foster growth in coming years (Chart 2.6).

Financial Market Developments 

The negative impact of uncertainty over fiscal and economic stability in Europe continues to be felt in global financial markets, despite actions by many central banks to ease monetary conditions. Bond yields for at-risk European countries remain elevated, and flight-to-quality capital flows have pushed down yields for North American and core European bonds.

Global equity markets generally declined over much of the second quarter of 2012, sparked by the impact of weaker global growth and renewed fears of a Greek default and potential exit from the euro area. Market tension was aggravated by concerns over Spain’s and Italy’s fiscal sustainability and questions over the ability of European leaders to take the necessary actions to contain the crisis. European bank equities were once again particularly affected, reflecting their exposure to the sovereign debt of a number of peripheral euro area countries. Markets have regained ground since July but most major global indices have only just returned to levels seen at the time of Budget 2012, with uncertainty continuing to be reflected in market volatility (Chart 2.7).

Concerns over euro area stability also resulted in higher borrowing rates for peripheral European countries in the second quarter of 2012. While these rates have since retreated to levels seen at the time of Budget 2012, this is largely a reflection of prospective actions to be taken by euro area institutions to centralize risk (in particular the ECB’s September announcement of its bond purchase plan), rather than improvements in the underlying economic and fiscal situations of the countries themselves. Moreover, bond rates for these countries remain elevated relative to core European countries and other perceived safe-haven destinations, including Canada (Chart 2.8).

Commodity Prices 

Renewed global economic uncertainty weighed on commodity prices in the second quarter of 2012. Price declines in the quarter were particularly steep for commodities that traditionally move in line with global growth expectations, such as crude oil and base metals.

Commodity prices have begun to recover since the lows observed in June, led by sharply higher grain prices, due to drought conditions in the U.S. and other grain producing countries. Natural gas prices have also increased from the depressed levels at the time of Budget 2012, which were the result of weak demand for natural gas, due to a mild winter, and unusually high inventory levels.

However, overall commodity prices have declined by 7 per cent since Budget 2012, and the level of commodity prices consistent with the Update 2012 average private sector forecast is expected to remain below its Budget 2012 level over the medium term (Chart 2.9).

Recent Canadian Economic Developments 

The Canadian economy has been resilient, despite a challenging external environment. Canada’s economic performance has been reflected in a robust labour market performance to date, with over 820,000 more Canadians working today than at the time of the trough in employment in July 2009—an increase of 4.9 per cent. Canada has outperformed all other G-7 economies in job creation over the recovery (Chart 2.10).

Over 90 per cent of all jobs created over the recovery have been in full-time positions with more than two thirds in high-wage industries (Chart 2.11). Encouragingly, the private sector has been the main source of job creation since the end of the recession, an essential condition for a sustained recovery and expansion, generating about three quarters of all new jobs since July 2009.

The employment situation in Canada contrasts sharply with that of the U.S., where employment remains significantly below pre-recession levels (Chart 2.12). As a result, the Canadian unemployment rate is ½ percentage point below that of the United States. The U.S. unemployment rate has exceeded the Canadian rate since October 2008, a phenomenon not seen on a sustained basis since the mid-1970s. Furthermore, when Canadian unemployment is measured on the same basis as in the U.S., the unemployment rate gap between the two countries increases to almost 1½ percentage points.^[1]

The stronger performance of the Canadian labour market is also reflected in the long-term unemployment rate (the number of people unemployed for a period of at least 27 weeks as a share of the labour force). Canada’s long-term unemployment rate stood at 1.6 per cent in 2011, slightly below its historical average since 1976 and well below the U.S. level of 3.9 per cent, which remains more than three times above its average over the same period.

Moreover, the Canadian labour market has maintained a much higher labour force participation rate (the share of the population 15 and over in Canada, and 16 and over in the United States, either working or actively seeking work), which indicates that there are fewer discouraged workers in Canada, as more of the unemployed are seeking work and finding it. In contrast, the U.S. participation rate has declined sharply and now stands near its lowest level in more than three decades. As a result, the labour force participation rate gap between the two countries has widened to its largest on record, averaging 3 percentage points so far this year. In the absence of such a marked decline in the U.S. labour force participation rate, the U.S. unemployment rate would have remained near its post-recession level of about 10 per cent.^[2]

Canadian economic growth has also been resilient compared to other G-7 economies, during both the recession and the recovery. Real GDP in Canada is now significantly above pre-recession levels—the best performance in the G-7 (Chart 2.13).

Economic growth over this period has been largely driven by sustained strength in demand from Canadian households and businesses, which has more than offset weak external demand. Real private domestic demand rose by 2.0 per cent in the second quarter of 2012, its 12^th consecutive quarterly increase. Domestic demand growth was largely driven by strength in business non-residential investment growth, which accelerated to 9.3 per cent in the second quarter. Canada is the only G-7 country to have more than fully recovered business investment lost during the recession, reflecting strong growth over the recovery (Chart 2.14).

On balance, Canada’s economy has performed better than other G-7 economies during the recovery. However, Canada has not been immune to global economic developments. Real GDP growth has been modest, averaging slightly over 2 per cent since the beginning of 2011 (Chart 2.15).

Renewed global uncertainty has also translated into sharply lower world prices for commodities produced in Canada, which has lowered GDP inflation and hence nominal GDP growth (the sum of real GDP growth and GDP inflation). Indeed, nominal GDP growth slowed to just 1.3  per cent on average over the first two quarters of 2012 (Chart 2.16). This has also translated into slower growth in government revenues.

 

Canadian Economic Outlook 

The average of private sector economic forecasts has been used as the basis for fiscal planning since 1994 and introduces an element of independence into the Government’s fiscal forecast. This practice has been supported by international organizations such as the IMF.

The Department of Finance regularly surveys private sector economists on their views on the outlook for the Canadian economy. The economic forecast presented in this section is based on a survey conducted in October 2012, and includes the views of 14 economists. This forecast incorporates the historical revisions to the Canadian System of National Accounts released on October 1 by Statistics Canada.

The October 2012 survey of private sector economists included BMO Capital Markets, Caisse de dépôt et placement du Québec, CIBC World Markets, The Conference Board of Canada, Desjardins, Deutsche Bank of Canada, IHS Global Insight, Laurentian Bank Securities, National Bank Financial Group, Royal Bank of Canada, Scotiabank, TD Bank Financial Group, UBS Securities Canada, and the University of Toronto (Policy and Economic Analysis Program).

The economists’ outlook for Canadian real GDP growth over the next five years is broadly unchanged, on average, from their expectations at the time of Budget 2012. Economists now expect growth of 2.1 per cent in 2012, unchanged from Budget 2012, and 2.0 per cent in 2013, down from 2.4 per cent in Budget 2012. This downward revision reflects more moderate growth expectations for the second half of 2012 and first half of 2013. Offsetting this, real growth is expected to be stronger over the 2014 to 2016 period (Chart 2.17 and Table 2.2).

The private sector economic outlook is consistent with continued modest growth in the global economy. In particular, this implies a gradual resolution of the euro area sovereign debt and banking crisis, with economic conditions in Europe gradually improving from the renewed weakness witnessed in mid-2012. Similarly, the outlook is consistent with U.S. policy makers modifying current legislation so as to avoid a large fiscal contraction in the near term.

While the private sector forecast for real GDP growth is largely unchanged since the budget, weaker global commodity prices during the first half of this year have reduced the outlook for GDP inflation in 2012. This has reduced the projected level of nominal GDP by about $25 billion (or 1.3 per cent), on average, over the 2012 to 2016 period, compared to the Budget 2012 outlook (Chart 2.18).

The economists expect unemployment rates to be largely unchanged from the outlook in Budget 2012. They project that the unemployment rate will continue to gradually decline over the forecast horizon and reach 6.4 per cent by 2017.

Private sector economists have lowered their interest rate projections over the forecast period. They now expect both 3-month treasury bill rates and 10-year government bond rates to be lower between 2012 and 2016, by an average of 30 basis points and 60 basis points, respectively, compared to the forecast presented in Budget 2012. The economists continue to expect the Canadian dollar to remain near parity with the U.S. dollar over the forecast horizon.

Table 2.2
Average Private Sector Forecasts
per cent, unless otherwise indicated

	2012	2013	2014	2015	2016	2017	2012–2016
Real GDP growth
March 2012 survey/Budget 2012	2.1	2.4	2.4	2.4	2.2	–	2.3
October 2012 survey/Update 2012	2.1	2.0	2.5	2.5	2.3	2.2	2.3
GDP inflation
March 2012 survey/Budget 2012	2.4	2.0	2.1	2.0	2.0	–	2.1
October 2012 survey/Update 2012	1.3	2.0	2.1	2.1	2.1	2.1	1.9
Nominal GDP growth
March 2012 survey/Budget 2012	4.6	4.4	4.6	4.4	4.2	–	4.4
October 2012 survey/Update 2012	3.4	4.0	4.7	4.7	4.4	4.3	4.2
Nominal GDP level (billions of dollars)
March 2012 survey/Budget 20121	1,844	1,925	2,013	2,102	2,190	–	–
October 2012 survey/Update 2012	1,822	1,895	1,984	2,078	2,169	2,262	–
Difference between Update 2012  and Budget 2012	-21	-29	-29	-24	-21	–	–
3-month treasury bill rate
March 2012 survey/Budget 2012	0.9	1.3	2.2	3.3	3.9	–	2.3
October 2012 survey/Update 2012	1.0	1.2	1.8	2.6	3.4	3.9	2.0
10-year government bond rate
March 2012 survey/Budget 2012	2.2	2.8	3.6	4.3	4.5	–	3.5
October 2012 survey/Update 2012	1.9	2.2	2.9	3.5	4.2	4.7	2.9
Exchange rate (US cents/C$)
March 2012 survey/Budget 2012	99.6	101.8	101.1	100.5	100.2	–	100.7
October 2012 survey/Update 2012	100.2	101.1	100.1	100.5	99.5	98.1	100.3
Unemployment rate
March 2012 survey/Budget 2012	7.5	7.2	6.9	6.7	6.6	–	7.0
October 2012 survey/Update 2012	7.3	7.2	6.8	6.6	6.5	6.4	6.9
Consumer Price Index inflation
March 2012 survey/Budget 2012	2.1	2.0	2.0	2.0	2.0	–	2.0
October 2012 survey/Update 2012	1.7	2.0	2.0	2.0	2.0	2.0	1.9
U.S. real GDP growth
March 2012 survey/Budget 2012	2.3	2.4	2.8	2.9	2.8	–	2.6
October 2012 survey/Update 2012	2.2	2.0	2.9	3.1	3.0	2.8	2.6
1 These values have been restated to reflect the historical revisions to the Canadian System of National Accounts released on October 1, 2012 by Statistics Canada. Sources: Budget 2012; Department of Finance March 2012 and October 2012 surveys of private sector economists.

Risk Assessment 

On October 29, 2012, the Minister of Finance met with the private sector economists to discuss the economic projections resulting from the October 2012 survey, as well as the risks surrounding the outlook. At that time, the economists agreed that the average forecast from the October survey was a reasonable basis for fiscal planning.

The economists highlighted a number of risks to the outlook, the greatest of which continue to be external to the Canadian economy.

The economists continue to see the euro area sovereign debt and banking crisis as a risk to the near‑term outlook, although they feel that the risk of a severe negative economic outcome in Europe had moderated since the time of Budget 2012. They noted that recent actions taken by euro area leaders—including the “Outright Monetary Transactions” measures announced by the ECB on September 6—represent significant steps in their efforts to successfully contain the crisis.

They also remain concerned about the possibility of significant fiscal tightening in the U.S. at the beginning of 2013—the so-called “fiscal cliff”—which could reduce U.S. growth. Moreover, the U.S. will reach the debt ceiling sometime in February or March, raising the risk of a repeat of the debt ceiling crisis in summer 2011. Further, the possibility that U.S. policy makers do not act to reduce government debt over the medium term could also weigh on the economic performance of that country.

On the domestic front, the main risk to the outlook identified by the economists continues to be the exposure of Canadian households to elevated levels of debt. A negative external shock to the Canadian economy that would translate into higher unemployment rates could trigger deleveraging on the part of those households holding elevated levels of debt. However, they noted that the recent additional actions taken by the Government to tighten government-backed insured mortgage standards would help to prevent households from becoming overextended.

On the upside, the economists saw the potential for stronger-than-expected growth in the U.S., particularly given recent encouraging housing market data. More importantly, growth could be significantly stronger than expected if U.S. policy makers are able to coordinate policy such that the 2013 fiscal cliff is avoided while implementing a medium-term plan to reduce government debt.

The economists also noted that the risk of a hard landing in China has diminished, as recent policy easing in China has resulted in a modest pickup in growth, which bodes well for commodity prices and global growth and trade, more generally.

The economists also noted that given the ongoing uncertain global economic environment, interest rates could remain lower for a longer period than is projected in the October survey.

Finally, world prices for the major commodities produced in Canada are key determinants of GDP inflation, and therefore nominal GDP. There are both upside and downside risks to the commodity price outlook, particularly in the short term. The private sector expectation for GDP inflation is consistent with commodity prices remaining at relatively low levels over the forecast horizon (Table 2.3).

Table 2.3
Commodity Prices Consistent With the
October 2012 Private Sector Forecast for GDP Inflation

	Current Price1	2012	2013	2014	2015	2016	2017
Prices consistent with the October 2012 survey
Commodity price index (2002 = 100)	211.8	218.2	214.8	216.2	220.1	223.4	225.2
Crude oil (West Texas Intermediate, US$/barrel)	86	94	89	90	93	96	97
Crude oil (Alberta prices, US$/barrel)2	82	84	79	80	83	85	86
Natural gas (Henry Hub, US$/MMBtu)	3.4	2.7	3.3	3.3	3.4	3.5	3.6
1 Average of two weeks ending November 2, 2012. 2 Canadian heavy crude oil price (at Hardisty, Alberta), week ending October 26. Canadian crude prices are assumed to grow at the same pace as West Texas Intermediate crude prices over the 2012 to 2017 period.

Planning Assumptions 

In light of these risks, for fiscal planning purposes, the Government has maintained the downward adjustment for risk to the private sector forecast for nominal GDP at $20 billion for 2013 through 2017 (Table 2.4). The downward adjustment for 2012 is reduced to $7 billion, as actual economic data are now available for almost two thirds of the year (meaning the risk of a downward shock for 2012 as a whole has been reduced). The Government will continue to evaluate economic developments and risks to determine whether or not it would be appropriate to maintain this adjustment for risk in the future. The fiscal outlook is presented in Chapter 3.

Table 2.4
Update 2012 Planning Assumption for Nominal GDP
billions of dollars

	2012	2013	2014	2015	2016	2017
October 2012 survey of private sector economists	1,822	1,895	1,984	2,078	2,169	2,262
Update 2012 fiscal planning assumption	1,815	1,875	1,964	2,058	2,149	2,242
Adjustment for risk	-7	-20	-20	-20	-20	-20
Addendum
Adjustment for risk in Budget 2012	-20	-20	-20	-20	-20	–

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^[1]   Conceptual differences raise the Canadian unemployment rate relative to the U.S. rate. In particular, Statistics Canada considers as unemployed those passively looking for work (e.g. reading want ads) as well as those who will begin work in the near future, while the U.S. Bureau of Labor Statistics does not include either group in its unemployment calculations. In addition, the Canadian methodology includes 15-year-olds (who have a higher-than-average unemployment rate), while the U.S. does not.

^[2]   The U.S. unemployment rate would have remained at about 10 per cent if the labour force participation rate had declined by about half as much as was the case, assuming that the number of employed remained the same.

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