The Canadian Conundrum - Views from the North

Ben Reitzes:

Welcome to Views from the North, a Canadian rates and macro podcast. This week I'm joined by Doug Porter, BMO's Chief Economist. This week's episode is titled The Canadian Conundrum.

I'm Ben Reitzes and you're listening to Views from the North. Each episode I'll be joined by members of BMO's FICC sales and trading team to bring you perspectives on the Canadian rates market and the macroeconomy. We strive to keep the show as interactive as possible by responding directly to questions submitted by our listeners and clients. We value your feedback, so please don't hesitate to reach out with any topics you'd like to hear about. I can be found on Bloomberg or via email at benjamin.reitzes@bmo.com. That's benjamin.R-E-I-T-Z-E-S@bmo.com. Your input is valued and greatly appreciated.

Doug, welcome to the show. First time I've had you on. I've been waiting for the right opportunity and I think this week is it, so thank you for coming on.

Doug Porter:

Well, it's been a long wait, but thank you very much for having me.

Ben Reitzes:

Doug's not a podcast aficionado, but I think that maybe we can change his mind this week, and I suspect the audience's feedback, all listeners out there, give Doug your feedback. Because I know many of you read his stuff and maybe then he'll come on again and we'll get some more of his excellent insights.

Why don't we start with the Bank of Canada and then we'll get to the topic that I really want to get to, but what were your thoughts on the Bank last week, Doug, and where do you see rates going forward?

Doug Porter:

I have to admit, this is one time where I thought Macklem's comments afterwards and some of the interviews he gave after, actually really mattered this time. Because my initial thought was, I wouldn't say it was a hawkish hold, but I thought they were serious about leaving the door open and that even the slightest inflation surprise over the next year could get them thinking about raising rates again at some point in the next, let's call it, the next three to four months.

But after I heard his remarks, especially on CBC, I think it became a lot more clearer that they're leaning very heavily to that they're done. They'd have to be seriously surprised on the inflation front I think to move off of that. And one way I would just look to is the fact that their inflation forecast, as I mentioned the day of, is actually higher than ours is for 2024. That's extremely unusual. Throughout this piece, I would say the bank's actually been pretty consensus in terms of inflation, now they're well above the consensus because we're a bit above and they're above us. So they've got inflation averaging 3%. To me, that would be a really disappointing performance for them if inflation only averages 3%. I'm sure they want to do better than that. That's the very high end of course of their tolerance zone. So I think basically what they're telling us is inflation really, really has to disappoint to get them going in.

Now having said that, I also think they're pretty clear that it's going to be a while before we can realistically look at rate cuts. It's interesting, you always got to be careful about just confirming your bias, but certainly Macklem's remarks certainly made it sound like they're not looking at rate cuts until the second half of the year, which pretty much lines up with our view. So I would say that the bottom line is, we really didn't change our call on this. We thought the Bank was done and we thought that they'd start going in the opposite direction, probably starting in the third quarter of next year.

Ben Reitzes:

So if we listen to that CBC radio interview, which by the way I would recommend folks out there listening, it was a pretty tough interview by the CBC interviewer. I was impressed and I kind of felt bad for Macklem, but he said in that interview that ... He talked about the middle of next year inflation being around 3.5%, and they'd have to be surprised on inflation being lower than they expect on this front for them to even consider maybe going even earlier than that for the timetable to get moved up. And you're saying that their inflation forecast is probably high, so the risks probably are skewed to them maybe easing earlier?

Doug Porter:

Maybe a bit earlier. I guess what I would say though is, it sounded like he was talking actually late 2024, so he might be a little bit later than us. But let's face it, if it's a close call, I think the bank will probably err on the side of being hawkish, like leaving things higher for longer than they would've otherwise done under normal circumstances.

Absolutely the last mistake they want to make is to ease prematurely. I have this feeling that they believe they made that mistake earlier this year. Not that they eased, but they gave the market the sense that they were done before they were really done. And of course we had the housing market flare back up almost immediately. They don't want to compound that kind of mistake by actually easing too early and having a second echo of inflation, either late next year or in '25, and then have to reverse course again. So I think if they make a mistake it's that they'll stay longer than you would've normally thought. Okay,

Ben Reitzes:

Okay. So two other aspects of this. One would be the growth side and the other would be the US. And this transition's pretty well into what you're writing about this week on the productivity problem that Canada has, and Canada's had for decades really, but it's gotten substantially worse in the past eight years. Productivity growth has effectively… is it is zero since 2017, and it's not far from zero since 2015. And over that period we've diverged substantially from the US.

And so there's clearly an issue there and from the Bank of Canada's perspective for now, I mean, you look at growth, we've had zero growth in the second quarter, slightly negative. Zero growth in the third quarter. The fourth quarter probably isn't going to look any better than that, and risks are surely to the downside, given policy still hasn't taken its full effect yet. And so if we're in recession or near it, how long can the Bank of Canada hold off, or is it just about inflation or is recession sufficient to get them to maybe rethink where they are?

Doug Porter:

I think if it was a serious recession it would get them enough to change their view and go earlier. But I think the key there is whether it's a true recession or just more of the economy essentially going sideways. And Macklem's even talked about this, how yes, there could be small negatives in their forecast since they've just got small positives. They could easily be wrong by a few tenths, but that's probably not enough to change the Bank of Canada's overall view. I think they'd really need to see the unemployment rate rising in a meaningful fashion. That's certainly possible. We have it going up to 6% or a little bit higher by the middle part of next year. We think that's probably just enough to convince them, but I think the unemployment rate have to rise a lot further to get the Bank to go earlier than that.

Just in terms of the growth forecast, the one thing I'll say is, so the Bank tries to be as realistic as possible. They don't try to bias their calls, but generally speaking that's one area where they have tend to be a bit above consensus over time. They do tend to be a little bit above consensus on growth. I do think if they make a mistake they want to put a bit of a rosier glow on things. It's interesting that they end up being right this year. The consensus at the start of the year was calling for a recession, they weren't. They were actually pretty close at the start of the year, but I think their call now is a bit overly optimistic and you probably wouldn't have to scratch them too far to get that answer from them as well.

Ben Reitzes:

Historical question for you, so for those out there who don't know, Doug remembers almost everything and is great at remembering all these historical facts. And of all the many things that Doug has taught me, which is a great many, I can't match his memory, when was the last time we had that kind of soft landing, where the economy would just have small negatives and the unemployment rate would only rise half to a percentage point, call it. Is that a realistic outcome?

Doug Porter:

We've had a few of those, believe it or not, and not in such distant memory. In fact, even the downturn that the US went through in the early 2000s, the tech wreck, officially Canada avoided a full-on recession during that episode. And that was after a pretty tough Bank of Canada series of raid hikes too, not comparable to this one. But because it was mostly just a complete cratering in business investment, Canada had its own Nortel meltdown at that point, but it didn't rise to the level of being a recession.

If we go a bit further back to the mid '90s, and this one does apply to the US, both of us went through, I would say the closest thing to a soft landing that we've had. Both the Bank and the Fed raised rates pretty aggressively through 1994. They stopped just in time, and we went through a sort of a mid-cycle correction in the economy where we did avoid a recession after a pretty ferocious set of rate hikes in both economies there in 1994.

That's probably the closest parallel I can find to it. The difference though is that was still pretty early in the cycle. And after the Fed and the Bank Canada were done, we then actually had a boom afterwards. I don't think we're headed that direction this time. I think it's just a matter of how deep of a slowdown are we looking at at this time.

Ben Reitzes:

Okay. I think, why don't we leave the Bank of Canada there and switch gears to what I really want to talk about and why I really have you on this week, although I like your Bank of Canada views also.

Doug is writing a piece on productivity for BMO's weekly publication, Focus, this week. And he outlines how, why, all of the reasons that Canada's productivity performance is as bad as it is. Can you just outline how weak Canadian productivity is at the moment, and you can go on and give some rationales or some explanations as to why we are as weak as we are.

Doug Porter:

So it is historic what we're going through right now. Of course, the decent data do not really go back that far, but I dare say we probably haven't seen this kind of weak productivity since the '30s. I suspect that was a lot worse back then, but in modern decades we've seen nothing like this. We had one year where productivity was negative in the early '90s, which was a very tough cycle for Canada.

But we're looking at an extended period here, like over a five-year period of time productivity has averaged a decline in Canada and that's basically unheard of. If you look over, say, the last 40 years, Canadian productivity growth has averaged about a percent a year, which in itself is not a very good performance, but to actually have a sustained period of declines is bad. And we can't blame the pandemic. I mean, the pandemic definitely messed things up for the economy in a number of ways, but if we look at US average productivity in recent years, it's a little below average, but it's not bad. It's not that unusual. Definitely the pandemic and the aftermath did weaken productivity a little bit, but that's not what we can really point the finger at here. I think it's a number of factors coming together at once.

If I had to distill it down to a single issue in Canada, I think just we've got extraordinarily weak business investment. There are a lot of factors at play, by the way, but I think frankly we've got a bit of a hostile environment I think for business investment. And it's weak, it's suffering. And whether it's relative to history or relative to the US, I do think there's more to it than that. But loaded on top of that we've also had near historic increases in population. And if you think of what drives productivity, it's basically a strong rising capital-to-labor ratio. We've had sort of the opposite. We've had very weak capital spending and we've had very strong labor force growth. So of course the outcome of that is very weak labor productivity gains.

Ben Reitzes:

I think a good example of that, the harshness of Canada toward business at the moment, are the battery plants that we've had to effectively buy and the ridiculously high cost of bringing those battery plants to Canada tens of billions of dollars to get two plants to Canada, and how many jobs is that going to create at the end of the day and is it worth all that money? I don't know. I hope so at the end of the day, but I guess we'll have to wait and see on that.

How do we fix this? Is there a fix? I mean, you outline a number of different issues and business investment. I completely agree. You look at investment, it cratered in 2015 as oil crashed and it really hasn't recovered. And we just haven't been able to find another sector to pick up the slack, and oil is not going to pick up the slack because investment in that sector is not really going to pick up, and the expectations of that are not realistic at this point. So how do we get more money coming into Canada on the investment side or how do we get Canadians to invest more, and maybe this goes back to housing.

Doug Porter:

Yeah, you can make a case that our fixation on housing is not helping the issue in general because that's where a lot of investment ends up going, whether it's personal investment or the actual business capital spending ends up in residential investment. Let's face it, that's not completely lost dollars. I mean, it does create a nice consumption flow. If we all want to live in castles, well, so be it. You're going to have to spend a lot of money in terms of residential construction, but for productivity it's a drag I would say overall.

But how do we fix this? First of all, I will say that this has been an issue I've been dealing with since I started as an economist, and that was lo’ those many years ago. So this is a topic that's been around for decades. And there was actually a serious attempt to address it in the late '80s and early '90s through things like the Free Trade Agreement with the US that eventually became NAFTA. The transition to the GST and away from manufacturers sales tax. There was also tax reform, believe it or not, lower marginal, lower corporate rates, in the early 2000s, which actually did lead to a period where we had some of the best productivity in the last 50 years in Canada in the late '90s and early 2000s.

Now, it just so happens the US also had very strong productivity growth during that. And I think rather than being Canada-led, it was probably driven more by fundamental factors beyond our borders, and essentially it was the take-up of the internet that I think really led to that boom in productivity, but some of the policies here in Canada helped. I think it actually does require a mindset change in Canada.

I think first of all, we have to be less hostile to businesses and business investment in general. I think there has to be less emphasis on redistribution and more on actually increasing what you're distributing, in other words creating wealth and not just sharing it around. I do think that the entire taxation system needs a rethink. I said in the piece, the last time we had a serious review of Canada's tax system was in the 1960s, the Carter Commission for history buffs. I do think we need a complete rethink on that front. But I think it's something more fundamental even than that. I do think we really need a change in attitude in general.

And frankly where it could start is with less of an assault on the tax front. We have very high personal marginal tax rates in this country. We have some of the highest in the world on that front, and they kick in at relatively low income levels. And I think right there that's one of the first things I would work on.

Ben Reitzes:

I couldn't agree more. I've harped on that low, not the high rate, but where the tax kicks in is always questionable I think at this point. Especially given inflation, not all of those brackets are inflation adjusted, and they're lagged as well, just to add insult to injury.

From the financial side of things, and one of the things you mentioned in your piece is that the Canadian dollar is one way that we've adjusted to our poor productivity performance over time. The dollar has come under a lot of pressure in recent weeks. I have trouble believing that's going to subside anytime soon, given the economic divergence here, what are the financial consequences of this? Is it just a consistently weaker Canadian dollar? Are there rate impacts as well? Should we worry about government finances at every level because of this?

Doug Porter:

Yeah, it's interesting. The textbooks tell you that productivity is the building block of real incomes, and so if you get lousy productivity growth, you should have weak personal income growth. But actually, labor compensation or wages in Canada have mostly kept pace with the US, even with weaker productivity. So workers have actually ended up doing okay in this world, even real compensate and the overall inflation numbers have been very similar in Canada to the US so over the decades.

That's not really the way that the productivity gap has expressed itself. It's really come more on the business side and part of it, yes, is the exchange rate, the exchange rate has acted as the equalizer. It's interesting, go back 50 years ago, Canada and the US were essentially at particular. Since that time we've had terrible productivity. We've had the same inflation, and yet here we are with the same inflation rate as the US over those 50 years, and the currency's down in the low 70s. So we've had this huge depreciation with the same inflation rate as the US. So it's sort of a subtle, quiet, corrosive effect on our standard of living here in Canada, and it is gone through the exchange rate.

The other effect has been that who's really absorbed the cost? Well, to some extent it's actually been margins here in Canada. Businesses have been dealing with higher unit labor costs here in Canada versus the US. And how that gets expressed on the financial side is you can partly point to, well, maybe this is one of the reasons why over time the Toronto Stock Exchange has just lagged out of the S&P by quite a wide margin over the many decades. Now some would also of course point to the makeup of the two indices, of course plays a big role. But I also think even aside from that sectoral breakdown, I think it has weighed on profitability here.

Now in a way it's almost like a vicious circle because we've got weak profitability, weak margins, that begets weak business investment, which weakens productivity further, and on it goes. And like I said, how it usually ends up and the way it does work away or basically dampen Canadian living standards is through a weaker exchange rate.

Ben Reitzes:

That doesn't sound like a great outlook.

Doug Porter:

It's not, sadly.

Ben Reitzes:

Well, I guess we have our work cut out for us as Canadians, and I guess from on our side that's banging the drum on this kind of stuff and hoping that policymakers pay perhaps a little bit more attention to these types of issues.

Doug Porter:

I think those sirens were just the emergencies coming to help try to fix productivity.

Ben Reitzes:

I was wondering if they were coming to revive the Canadian economy.

Doug Porter:

Yeah.

Ben Reitzes:

Well, I guess we'll have to wait and see on that. Any other topics?

Doug Porter:

I guess just the one thing I would say is it's not as if Ottawa has been blind to this over the years. Even the current government did make a stab at trying to support capital spending, whether it was through incentives or business tax credits. They have tried a number of things over the years, but I don't think tinkering around at the edges really does that much. As I said, I think you have to fundamentally change the attitude in Canada.

And by the way, I will say, the US is a very tough bar to live up to. They do have one of the higher productivity levels in the world. There are some economies that are a bit higher, which I go into, but the US is definitely up there. It is a high bar. There are some structural factors in Canada that do mean it'll always be tough for us to get up to US levels, and one of it is just basically the scale of our businesses does tend to be a little bit smaller. We don't have the same tech sector that the US has, and the tech sector is really led the way on productivity, but that doesn't mean we should give up. You basically, on the things you can control, you have to do the best job that you can do, and I don't think we're doing the best job by any means.

Ben Reitzes:

Okay. Doug, thanks for coming on. For all those listeners out there, if you are a BMO client, you can get on the distribution list from Economics and Focus is the publication that this is coming in on Friday. It's currently Wednesday afternoon. So feel free to reach out to your BMO rep and then they'll get you on that list. For those of you who are not BMO clients, you can see it on our website. I highly recommend you read this, whether you're a policymaker, economist, layperson, no matter what it is, take a read. It's very much worthwhile.

Doug, thanks for coming on and I hope to have you on again.

Doug Porter:

Well, thanks for having me. My pleasure.

Ben Reitzes:

Thanks for listening to Views from the North, a Canadian rates and macro podcast. I hope you'll join me again for another episode.

Speaker 3:

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