- Activity in the service sector has already grown 2.6% past its pre-recession peak, suggesting that Canadian excess supply is closer to 1% than to 2%.
- Based on our calculations for the service sector, excess supply in the goods-producing sector should stand at 4% in order to be congruent with the monetary authority’s official measure of the output gap.
- The problem is that this does not jibe with the fact that the manufacturing capacity utilization rate has already bounced back to its long-term average. Consequently, to our eyes, there is presently a great deal of uncertainty surrounding the measure of the output gap in Canada.
- The Bank of Canada today holds sway over a larger portion of economic activity in light of the fact that external shocks now affect no more than 29% of the economy compared with nearly 50% just 10 years ago. Consequently, our calculations regarding the output gap carry serious implications for monetary policy.
- In this era of extremely low real interest rates, the fact that inflation expectations are very well anchored might encourage the BoC to apply a more accommodating monetary policy than it normally would, the upside risk to inflation not being as strong under the circumstances. However, this offers no fail-proof guarantee after looking at our analysis of the output gap.
- In this context and given its bearish outlook, the BoC runs the risk of being surprised on the upside by stronger U.S. economic growth than anticipated. Hence our baseline scenario now calls for new key rate hikes as of 2011Q2.
Looking back, the Canadian recession lasted a relatively short time all in all. However, a breakdown of GDP yields a different picture of the sectors of the economy. Indeed, while services GDP fell for two quarters, goods GDP, instead, did so for four.
All told, the downturn proved much more severe for goods, the scale of the chart on the right-hand side being
larger than the one on the left. As illustrated in the first chart, the recovery unfolded rather rapidly, with gains early on in excess of 3% for services and above 6% for goods.
Back to normal
The situation regarding the manufacturing sector seems to have improved considerably as well. Statistics Canada recently announced that the manufacturing capacity utilization rate this side of the border had just bounced back to its average for the period spanning 1987 to today. There is no contesting that the utilization rate has thus traced a very tight v-shaped recovery.
This is an extremely positive development for the Canadian economy, especially at a time when the counterpart statistic in the United States is fairing very poorly indeed.
A strange decoupling
This said, the manufacturing capacity utilization rate’s recovery clearly seems to be at odds with the Bank of
Canada’s measure of the output gap, the aim of which it is to determine whether the Canadian economy on the whole is at equilibrium, in a situation of excess demand or in one of excess supply.
In fact, while the utilization rate has returned to its longterm average, the monetary authority’s official measure of the output gap suggests, instead, that the Canadian economy is presently in a position of excess supply by as much as 2%, that is, squarely in disinflationary territory.
What strikes us as particularly strange presently is the difference that exists between quarterly changes in the
manufacturing capacity utilization rate and those in the output gap (the measure of the rate for the economy as a whole).
As shown in Chart 4, the dynamic seems to have been turned completely upside down, as though the amplitude of movements in the output gap were disconnected from those in the manufacturing capacity utilization rate. From a historical viewpoint, this new dynamic raises a number of questions.
What is even stranger is the decoupling between the level of the manufacturing capacity utilization rate and that of exports. Today’s gap between the two statistics is unprecedented.
How is this possible? There are essentially two reasons for this. The first is that the recession resulted in a
destruction of capacity per se, that is, the economic downturn can be explained not only by a demand shock,
but also by a supply shock. The second reason is that the Canadian manufacturing sector today is selling its
merchandise more than ever domestically in Canada rather than exporting it. The data on manufacturers’
shipments attests to this new dynamic very clearly.
Welcome to the “new” Canadian economy
This brings us to the conclusion that the external shocks that hit the Canadian economy no longer affect activity with the same force they did no more than ten years ago.
Indeed, analysts will probably be surprised to learn that in the short span of ten years, thanks to Asian competition and to the loonie’s appreciation, the Canadian economy has grown considerably more closed.
At time of writing, all the beneficial effects of the FreeTrade Agreement had gone up in smoke. After the ratio of exports to GDP shot up sharply beginning in the early 1990s to reach a high of 46% in 2000, it then literally
tumbled to settle today at 29%, which is to say essentially back where it started from 20 years ago.
All this has profound implications for Canadian monetary policy. The Bank of Canada today holds sway over a much larger portion of economic activity in light of the fact that external shocks now affect no more than 29% of the economy compared with nearly 50% just ten years ago.
Final domestic demand, which is something that can be influenced by interest rates, accounts for a record share of overall activity. This explains why the last rate cuts in Canada had such an impact in stimulating the economy.
Ultimate mechanics of output gap
Getting back to our subject, if monetary policy nowadays holds greater sway than it did ten years ago, measuring the output gap as accurately as possible becomes all the more important for the implementation of monetary policy.
As illustrated in Chart 8, activity in the service sector hasalready grown 2.6% past its pre-recession peak. The
same cannot be said for the goods-producing sector, which is still down 4.2%, although it has recovered 8%
since bottoming out. What should we make of this?
If the monetary authority asserts that the Canadian economy’s speed limit (potential GDP growth rate) since
the onset of the recession is in the vicinity of 1.8%, this would mean that, in theory, for the output gap to be at
equilibrium, services would have had to grow 3.6% in the past two years1% We are assuming here that the 1.8 . applies to services on the strength of the fact that they do after all account for 72% of Canadian GDP.
This would place the output gap in services in an excess supply position of only 1% rather than 2% as the official measure would have it. Looking at it from a different angle, this would also mean that, given the output gap of about 1% in the service sector, the goods-producing sector should be in a position of excess supply on the order of 4% (based on its 28% share of activity), which would peg excess supply in the economy as a whole at 2%.
As it turns out, 4% excess supply in the goods-producing sector is not consistent with the fact that the
manufacturing capacity utilization rate is already back at its long-term average. Consequently, to our eyes, there is a great deal of uncertainty at present surrounding the measure of the output gap in Canada.
Monetary implications
Partly because U.S. monetary policy has become even more accommodating since November, the Bank of
Canada has had to put a hold on its rate hikes in order to prevent the loonie from overheating ahead of time.
At 1.0% in nominal terms, Canada’s present key rate appears low in real terms. Indeed, the real rate stands at more or less -100 basis points with inflation at 1.8%, that is, already very close to the official target of 2%. How long will real rates be kept this low considering that the Canadian economy is already in expansion mode?
We suspect that the Bank of Canada feels it can live with such a monetary policy owing to a change in the weighting of the determinants of inflation in Canada. The output gap seems to have been less affected by
inflation recently than it had during the previous economic cycle. Indeed, even if the output gap has fluctuated widely from 2007 to today, inflation has shown no trend, be it upward or downward. We could almost draw a straight line through Canadian core inflation since 2008 whereas the output gap has registered some brusque movements over the same period.
It may be that the weight of inflation expectations among the determinants of inflation has increased recently in
Canada on account of the heightened credibility enjoyed by the monetary authority. Hence, the Bank of Canada could, in a scenario of this sort, allow itself to apply a more accommodating monetary policy than it normally would, as the upside risk to inflation would not be as strong all in all.
However, this offers no fail-proof guarantee, especially as we suspect that the output gap is probably in less of an excess supply position than the official measure suggests, based on the current data regarding growth in activity in the service sector and production capacity rates in the manufacturing sector 2 .
How sensitive is external sector?
Presently, the Bank of Canada seems to be putting a lot of emphasis in its monetary policy on the risks associated with the European situation as well as on the state of the U.S. economy. We do not necessarily share the opinion of the central bank on a few points at least.
First, the North American stock markets have rallied strongly since the Federal Reserve’s November
announcement, and the European situation has generated no risk premium on the financial markets, which seem to be able to discriminate among the different economic regions.
Second, as a result of the new and surprising tax plan in the United States, U.S. demand should firm up next year, and this should benefit the Canadian external sector.
Third, the loonie’s appreciation, though propelled in part by foreign capital inflows, does not worry us beyond
measure. As we clearly demonstrated, the Canadian economy is much more closed than it was ten years ago,
not to mention that the share of Canadian exports to the United States is no longer 85% but rather only 70%.
Given that Canada’s real effective exchange rate has dropped back to the trough it reached in 2000 and is low on a historical basis (Chart 14), the expected rise in U.S. demand next year should stimulate exports even if the loonie appreciates. This is because any increase in demand south of the border has three times as great an impact as does the exchange rate, proportionally speaking.
In our opinion, then, the Canadian monetary authority is rather bearish on the world economy next year and could be surprised on the upside, especially by stronger U.S. economic growth than anticipated.
Under the circumstances and in light of the fact that the output gap is probably in less of an excess supply position than the official measure indicates, the Canadian real key rate seems very low to our eyes. Hence, our baseline scenario now calls for new key rate hikes beginning at the end of 2011Q2.
Conclusion
- Activity in the service sector has already grown 2.6% past its pre-recession peak, suggesting that Canadian excess supply is closer to 1% than to 2%.
- Based on our calculations for the service sector, excess supply in the goods-producing sector should stand at 4% in order to be congruent with the monetary authority’s official measure of the output gap.
- The problem is that this does not jibe with the fact that the manufacturing capacity utilization rate has already bounced back to its long-term average. Consequently, to our eyes, there is presently a great deal of uncertainty surrounding the measure of the output gap in Canada.
- The Bank of Canada today holds sway over a larger portion of economic activity in light of the fact that external shocks now affect no more than 29% of the economy compared with nearly 50% just ten years ago. Consequently, our calculations regarding the output gap carry serious implications for monetary policy.
- In this era of extremely low real interest rates, the fact that inflation expectations are very well anchored might encourage the BoC to apply a more accommodating monetary policy than it normally would, the upside risk to inflation not being as strong under the circumstances. However, this offers no failproof guarantee after looking at our analysis of the output gap.
- In this context and given its bearish outlook, the BoC runs the risk of being surprised on the upside by stronger U.S. economic growth than anticipated. Hence, our baseline scenario now calls for new key rate hikes as of 2011Q2.
Full report: Uncertainty surrounds official measure of output gap in Canada
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