Canada’s 2005 Article IV Consultation highlights that it has benefited from a strong institutional framework and continuing structural reforms. Inflation targeting and structural reforms have yielded an enviable macroeconomic performance, including the fastest growth rate and the strongest budget position in the G-7. The outlook for the economy is broadly favorable, but external developments are creating uncertainties. The Bank of Canada appears to have room to maintain a patient and measured approach to withdrawing stimulus.

Abstract

Canada’s 2005 Article IV Consultation highlights that it has benefited from a strong institutional framework and continuing structural reforms. Inflation targeting and structural reforms have yielded an enviable macroeconomic performance, including the fastest growth rate and the strongest budget position in the G-7. The outlook for the economy is broadly favorable, but external developments are creating uncertainties. The Bank of Canada appears to have room to maintain a patient and measured approach to withdrawing stimulus.

1. This note reports on recent developments since the staff report was issued. These developments do not alter the thrust of the staff appraisal.

2. Economic indicators have moderated somewhat in the fourth quarter. Following an annualized 3¼ percent increase in real GDP in the third quarter of 2004, growth slowed to a 1½ percent rate in October and November. Although the manufacturing sector continued to expand and capacity utilization reached a 16-year high, job creation has been flat and business confidence declined in the last quarter of 2004. However, the unemployment rate remained around 7 percent, and core inflation inched up slightly to 1¾ percent in December 2004.

3. The staff continue to project 2005 growth at slightly below 3 percent. The staff’s growth projection—which is close to the January private sector consensus—is supported by the easing of the exchange rate to below the psychologically important mark of US$0.80 per Canadian dollar during the past month, the stabilization of net exports in November and December after the sharp drop in the third quarter, and the pick up in consumer confidence and other leading indicators in January.

4. The Bank of Canada again left its target for the overnight interest rate at 2½ percent at its January 25 fixed action date. In the accompanying press release and Monetary Policy Update, the Bank noted that the economy was expected to grow 2.8 percent in 2005, somewhat slower than expected earlier, and suggested that the pace of reduction in monetary stimulus was likely to be slower than envisioned in its October report. With the output gap projected to close only in the second half of 2006, core inflation is not expected to return to the 2 percent mid-point of the Bank’s target range before the end of next year.

5. Financial markets are currently pricing in only one 25 basis point rate increase this year, in the third quarter. Long-term interest rates have declined by about 80 basis points since mid–2004, notwithstanding the combined 50 basis points increase in short-term interest rates in September and October. The inflation premium implicit in 30-year government inflation-linked bonds has fallen to 2 percent, almost a full percentage point lower than at the same time last year.

6. The FY 2005/06 Budget is to be released on February 23. Given the relatively tight budget constraint, analysts expect no major spending or tax initiatives. Statements by Finance Minister Goodale suggest that some of last year’s surplus could be used to boost federal daycare spending, while some news reports also suggest that the budget could include proposals to reduce corporate taxes.

Canada: Staff Report for the 2005 Article IV Consultation
Author: International Monetary Fund