Abstract
KEY ISSUESEconomic outlook: The Canadian economy has expanded at a solid pace since 2013, butrebalancing of growth away from household consumption and residential investment remains incomplete, owing mainly to weak business investment. Growth momentum is expected to continue alongside a strengthening U.S. recovery despite substantially lower oil prices. Risks to the outlook are modestly tilted to the downside given sluggish global growth, effects unfolding from sharply lower oil prices, and housing market risks. Key domestic vulnerabilities in housing markets and the household sector remain elevated but contained fro m a financial stability perspective.Policies for balanced and sustained recovery: An appropriate policy mix should help facilitate rebalancing to generate a broader and more durable recovery, reduce domestic vulnerabilities, and further strengthen financial system resilience:• Macro policies: Monetary policy can remain accommodative for now given that inflation expectations are well-anchored, stronger business investment is still a missing link, risks to an export-led recovery are to the downside, and housing markets are expected to cool as U.S. interest rates rise and with lower oil prices. Fiscal consolidation should proceed in light of longer-term challenges at the provincial level, but federal authorities should consider adopting a neutral stance going forward, using available fiscal resources for targeted measures to support growth. Structural policies to improve productivity in the economy would increasingly need to complement this policy mix.• Housing sector and financial sector policies: Further macro-prudential policy action may be needed to guard against risks to financial stability if household balance sheet vulnerabilities resume rising. Reforms to limit government exposure to housing markets and encourage appropriate risk retention by the private sector should continue. Improving complex coordination across federal and provincial authorities in supervision and stress- testing of depository institutions and strengthening macro-prudential and crisis management frameworks will reinforce the resilience of Canada’s financial system.Policy response to past advice: Since the 2013 Article IV Consultation mission, the authorities have taken some further steps to limit taxpayer exposure to the housing sector and strengthen mortgage insurance underwriting practices. Some work on FSAP recommendations has also started to enhance stress testing, address data gaps, and towards establishing a cooperative capital markets system. The authorities have also intensified theirefforts towards addressing interprovincial trade barriers and export diversification.
1. This note reports on information that has become available since the staff report (SM/15/10) was issued and does not alter the thrust of the staff appraisal.
2. The Bank of Canada unexpectedly lowered its policy rate by 25 basis points on January 21. In the wake of substantially lower oil prices and increased uncertainty around an otherwise solid economic outlook, the Bank revised down its projections for GDP growth by 0.3 percentage points to 2.1 percent for 2015, mostly reflecting slower growth in the first half of the year. Headline CPI inflation was also revised down below the target range of 1–3 percent in 2015. In a context of higher uncertainty, the Bank stated that monetary easing is “intended to provide insurance” against downside risks to the inflation profile and financial stability, support the sectoral adjustment needed to strengthen investment and growth, and bring the Canadian economy back to full capacity and inflation to target within the projection horizon (end-2016). In response to the interest rate cut by the Bank of Canada, on the day of the announcement, the Canadian dollar depreciated further, falling by about 2 percent vis-à-vis the U.S. dollar, stock prices rose by almost 2 percent, and short-term bond yields fell sharply (by about 30 basis points) while long-term yields edged down slightly.
3. Downside risks have risen in light of further oil price declines. Since the staff report was issued, oil price projections for 2015 have declined further by about 12 percent based on market futures. This poses further downside risks to staff’s growth and inflation forecasts for 2015, mainly through weaker investment in the energy sector. In this context, the central bank’s policy action is in line with staff advice to use available monetary policy space to mitigate the unfolding effects of downside risks to the outlook that have intensified.
4. There are welcome signs that activity in the Canadian housing sector may be cooling, especially in some overheated markets. Against the back drop of weaker oil prices and terms of trade, home sales fell in December (-5.8 percent, m/m) on the back of muted growth during the second half of 2014. The number of newly listed homes fell nationally (-6.8 percent, m/m), with Calgary and Edmonton registering much larger declines. Residential construction activity continued to moderate, with starts declining to around 180,000 units in 2014, slightly down from 2013 levels. The number of completed and unabsorbed dwellings continued its downward trajectory in 2014, reaching 201,000 by the end of the year. House prices though rose 5.4 percent (y/y) in December (close to the 5.3 percent pace in November), led by increases in Calgary and the Greater Toronto Area. House price appreciation in Calgary, however, has moderated slightly to 8.8 percent in December, down from 9.2 percent (y/y) in the previous month.
5. Recent indicators still suggest solid activity continues in the non-energy sector. The Bank of Canada’s winter Business Outlook Survey continues to provide signs of strengthening demand, especially among export-oriented firms and manufacturers. However, the outlook for businesses linked directly or indirectly to the energy sector has deteriorated. Firms anticipating a positive impact from the U.S. economic outlook are more optimistic than others. Furthermore, hiring intentions and investment plans are more robust for manufacturing than other sectors. Canadian manufacturing sales though decreased by 1.4 percent in November, below consensus estimates. The decline was widespread but mostly driven by motor vehicles, which fell on a monthly basis, but total year-to-date sales were still 5.2 percent higher than in the first eleven months of 2013.