Canada’s economy is gradually normalizing.
While speaking at the Washington Forum last week, Bank of Canada Governor Tiff Macklem noted that over the 20 years preceding the pandemic, economic growth averaged 2.2 per cent. This year, the Bank of Canada expects real GDP growth to come in at 1.5 per cent, returning to the average 2.2 per cent trend in 2025.
The Globe and Mail recently spoke with Sal Guatieri, senior economist at BMO Capital Markets, who addressed Canada’s economic growth, interest rate expectations, depreciating Canadian dollar and the key risk that he sees to the economy.
Your 2024 real GDP forecast for Canada is 1.2 per cent, relatively unchanged from 1.1 per cent reported in 2023. Could this expectation be too low, especially if rate cuts occur in the second half of the year, which could stimulate economic growth?
BMO’s senior economist Sal Guatieri.Supplied
It’s possible. There’s a couple of good things going for Canada’s economy. Our major trading partner is showing a lot of resiliency. The U.S. economy is growing at upwards of a 2 per cent rate. That is supporting our exports and no surprise it’s exports that are leading Canada’s economic growth in the past year.
The other plus for the economy is, as you mentioned, interest rates are expected to decline and fairly soon. We expect the Bank of Canada to begin cutting rates in June and to reduce rates by a full 75 basis points this year and then another 125 basis points by the middle of 2026.
Now, the one issue there is it takes a while for lower interest rates to affect the economy. So, we probably won’t see the boost to activity this year. That’s more likely a story for 2025 and that is when we expect stronger growth in the 2 per cent range to occur.
At the start of the year, you were expecting four rate cuts – 25 basis points each totalling 100 basis points. You trimmed that down to three rate cuts totalling 75 basis points. Could we see even fewer rate cuts by the Bank of Canada?
We did start the year expecting the Bank of Canada to cut rates four times, but we recently shifted that back to just three rate cuts, not for domestic considerations – if anything, the inflation data warrant rate cuts fairly soon and at a fairly steady pace. The situation is all centred on the U.S. and the recent spate of disappointing inflation news out of that country, which spurred us to push back our expectations for Fed easing. We now expect the Fed to cut interest rates just twice this year, while at the start of the year we were expecting four rate cuts from the Fed.
There are two implications for the Bank of Canada. If the Bank of Canada cuts interest rates much more aggressively than the Fed, the Canadian dollar will weaken even further. There is a risk if the Canadian dollar weakens much further, that could delay rate cuts from the Bank of Canada or at least result in a much shallower course of easing than what we currently anticipate. If the Canadian dollar weakens much further that will put upward pressure on import costs and inflation and might also add too much support to the economy. So, the Bank of Canada will need to be mindful of what the Fed does. The second consideration is that for the longest time we were seeing very good inflation news out of the U.S., actually through most of last year. It’s just recently, the first three months of this year, that we’ve been disappointed by the inflation news. It’s quite possible that we could see a setback in the inflation data in Canada as well. For that reason, I think the Bank of Canada will be a little cautious as well.
Given your expectation that rates will come down sooner and by a larger amount in Canada, will the weakness that we’ve already seen in the Canadian dollar relative to the U.S. dollar continue?
For the longest time markets believed the Fed would move before the Bank of Canada and in some cases more aggressively. That’s now turned around where the market does anticipate the Bank of Canada moving before the Fed and perhaps more aggressively than the Fed. That’s very much in line with our view as well. Those expectations are priced into the Canadian dollar’s weakness. The Canadian dollar has hit a more than five-month low against the U.S. dollar recently, largely on the back of the shift in central bank expectations.
Our general view is we probably have seen the worst for the Canadian dollar’s depreciation and do anticipate some actual modest strengthening in the Canadian dollar this year, not so much for domestic reasons, but more so for external reasons and it largely comes down to a view that the U.S. dollar is still close to its all-time highs on a trade-weighted basis and will start depreciating once the Fed begins cutting interest rates.
What are your thoughts on inflation?
We’re cautiously optimistic on the inflation outlook for Canada simply because of the recent progress; it has fallen a little faster than we anticipated.
The bank has two favourite measures of core inflation. The first one is the CPI median, that’s basically your middle item in the consumer basket. Right now, the year-over-year rate is 2.8 per cent, and it’s coming down. And if you look at the increase in the last several months, it’s only been up 1/10 of a per cent. So at a three-month annualized rate that metric is only up 1.1 per cent. On a six-month basis, it’s up 2.2 per cent. That’s telling you if the median measure continues to rise very slowly in coming months, the year-over-year rate will be coming down pretty quickly.
The other metric that the Bank of Canada likes to follow is called the CPI trim, which omits some of the most volatile items each month from the basket. The year-over-year rate is 3.1 per cent, which of course looks uncomfortably high. But, it’s been running very calmly in recent months so that the three-month rate is only 1.4 per cent and the six-month annualized rate is 2.5 per cent.
That’s giving the Bank of Canada and us confidence that apart from some of the inflation in the housing market – rents, for example – the Bank of Canada’s restrictive policy is working.
We’re quite optimistic that inflation will continue to trend lower and probably we’ll get back to the 2 per cent target on a sustained basis some time next year. If that’s the case, barring a disappointment with the next CPI report, the April report, we think the Bank of Canada will start the easing cycle in June and will cut interest rate 75 basis points this year.
In BMO’s economic outlook report, corporate profits after tax are forecast to decline 4.1 per cent year-over-year in 2024 and fall 1.9 per cent in 2025. What does this suggest for this earnings season?
Our economy, even though it’s showing signs of stabilizing and avoiding a recession, is very weak. Real GDP is only up about 1 per cent in the past year and we expect it to only be up 1.2 per cent this year, which is really not much of a pickup from last year at all. Importantly, it’s below potential economic growth, which is thought to be just under 2 per cent, and it’s below long-term normal growth. Importantly, growth is negative in per capita terms. If you strip out 3 per cent population growth, real GDP is actually contracting. That’s telling you that the economy is fundamentally pretty weak in Canada, unlike in the U.S., and a weak economy, especially if it’s driven by sluggish consumer spending, is a recipe for weak corporate profitability.
Is business investment recovering?
We believe business investment will start to recover very gradually in the first quarter of this year. Up to the fourth quarter of last year, there were no signs of recovery. It’s been contracting for several quarters, it’s down almost 3 per cent on a year-over-year basis as of the fourth quarter. It’s a reflection of weakness in consumer spending, concerns about a recession both in Canada and globally, and also a reflection in some ways of weak productivity, and a lack of competitiveness. That’s all undermined business investment in Canada, and unfortunately, that’s fed back into keeping labour productivity fairly weak in Canada.
We don’t have much evidence of a recovery yet, but we expect that we will see business investment grow at least on a quarter-over-quarter basis gradually this year as the economy starts to pick up through the year in anticipation of lower interest rates.
What do you see as key risks to the economy?
The biggest risk is stubborn inflation. I don’t think it’s a huge risk per se for Canada because our economy is weak, our unemployment rate is going up. It’s more of a risk stemming from the United States where the economy is still strong, the labour market is tight, the unemployment rate is low. I think there is a risk that we could see stubborn inflation pressures in the U.S. keeping the Fed on the sidelines, and that might limit how much the Bank of Canada can cut rates this year.
It’s pretty clear that policy is restrictive in Canada. That’s why our economy is growing at a well below normal rate and it’s actually contracting in per capita terms. There’s only so long you could withstand restrictive policy before your economy does slip into a recession.