The economic outlook

The Canadian and U.S. economies ended 2002 on a soft note and 2003 opened in similar fashion. Until mid-2003, the Canadian economy is forecast to continue to grow faster than the U.S. The second half of the year is likely to see stronger economic growth, particularly in the United States, where U.S. business investment will finally recover with enough vigour to offset some loss in momentum of household spending which had been leading growth for some time. Improved U.S. economic growth expected to be driven by the cumulative effect of the very low interest rates in place since late 2001, stimulative fiscal policy and progress in the elimination of some of the imbalances that developed in the recession in 2001.

The roots of Canada’s superior economic performance go back several years. Canada didn’t experience as strong an investment boom as the United States in the late 1990s, so there was less retrenchment in this area in Canada in the slowdown of 2001. Moreover, business investment in Canada began to recover in the second quarter of 2002. A relatively smaller high-tech sector and a relatively larger oil and natural gas production sector in Canada acted in Canada’s favour in recent years. Economic growth held up much better in Canada in 2001 and revived early in 2002. These differences translated into a sharper fall in corporate profits in the United States and little in the way of recovery through 2002. In contrast, corporate profits in Canada came back sharply in the first quarter of 2002.

Household spending was strong in both economies in 2002. In Canada, it was supported by the creation of approximately 560,000 jobs. This was one of the largest annual increases in the past 25 years. The strong gains in employment and low mortgage interest rates provided strong support to housing markets and housing starts exceeded the 200,000 mark last year – the highest level since 1989. Neither employment growth nor housing activity is expected to be as strong in 2003, but the softening in activity is forecast to be gradual, with housing starts dropping to around 185,000 units.

The U.S. Federal Reserve and the Bank of Canada have stated their intentions on several occasions to move rates up to less stimulative levels when economic conditions warrant. In fact, the Bank of Canada began this process in the spring of 2002, but paused later in the year. Both central banks are likely to wait until mid-year before they begin to boost rates, as both will want to be certain that their respective economies are on a strengthening and sustainable growth path. Each central bank is expected to tread fairly lightly in raising rates with the result that short-term interest rates will still be providing stimulus to growth in both countries into 2004. With virtually no spare capacity in the Canadian economy, a better than expected economic performance in Canada would push the Bank of Canada to speed up its tightening.

A pickup in world economic growth should provide some improvement in non-energy commodity prices that in turn should provide some lift to the Canadian dollar. Additionally, the positive spreads between short-term interest rates in Canada and the United States should prove supportive of the Canadian currency. Nevertheless, geopolitical uncertainty may act as a restraint. Thus, the Canadian dollar is unlikely to exceed 67 U.S. cents by the end of 2003.