2025 Canada Economic Outlook: On the Mend

Speaker 1:

In today's episode, we're pleased to introduce Chief Economist and Managing Director of BMO Economics, Doug Porter, who will provide his outlook for the Canadian economy.

Speaker 2:

Welcome to Markets Plus we're leading experts from across BMO discuss factors shaping the markets, economy, industry sectors, and much more. Visit bmocm.com/markets+for more episodes. The views expressed here are those of the participants and not those of BMO capital markets, its affiliates or subsidiaries.

Doug Porter:

Hello everyone. Thanks for joining us. So I think I've said in each one of the last couple of fall economic outlooks that this is a very complex economic environment. That is definitely not changed. It's no different this year. But what is different is we're dealing with a very different interest rate and inflation landscape than we saw in the last couple years. Instead of very high inflation and rising interest rates, we've actually seen quite a substantial decline in inflation in the past year alone and we've now finally got interest rates coming down as well. Having said that, of course, the question on everyone's mind is what's the outlook for Canada's economy now that we have the completely different US election scenario that we've been dealt with over the past week? I think the broad contours are reasonably well known, even if of course we're all awaiting the details.

And I must say that while there's lots of speculation in terms of what Mr. Trump might do on the tax front or the tariff front, I think we really do have to wait until we see exactly what gets through Congress, exactly what he does on the trade side and over what time period he enacts these kind of policies before we really begin to dramatically change our economic outlook. And I'll give you just one example. After he was first elected in 2016, we initially saw a big run-up in the US dollar in long-term interest rates on the assumption that we're going to get a lot more inflation and much higher interest rates in the US and pretty much all of that wore off within three years and then of course, covid hit and we had a completely different economic landscape. So I think the main message here is yes, we really do have to wait to see exactly what Mr. Trump does and over what time period that it gets enacted.

But I think what we can pull away from the very broad scope is it's likely to be the case that the policies that we're going to see over the next four years will tend to put a bit of upside for growth, a little bit more upside for inflation than we would've otherwise had somewhat higher long-term yields and a somewhat stronger US dollar.

But I think I'm putting the cart ahead of the horse a little bit. Let's take a step back and look at the kind of economic environment that we're faced with heading into the next four years. First of all, from a very big-picture lens, I would say the surprise, the pleasant surprise has been how resilient the global economy has been, not just in the last year, but really over the last couple years. Pretty much everyone has managed to see some growth. In a number of cases. For instance, India for example, have managed to actually grow a little bit above expectations. And when we add up all these major global economies, we're looking at overall world growth of a bit better than 3%, and this is so-called real growth or after inflation. And we're looking at something similar again in 2025. We do see some economies moderating a little bit, but overall we do see the global economies still managing growth of a bit better than 3%.

Just to put that into context, that would be a little bit below the global economy's long run average, but not far below. And I have to say that to me that's very impressive that the global economy has managed to grow at almost an average pace given everything that's stacked up against it, a couple wars, still relatively high inflation and still high interest rates in much of the world, and yet the global economy still managed to push through.

Now the US economy, I do really think this is the big story, the main reason why the global economy has been so resilient because the world's largest economy, the US economy has quite simply done a lot better than expected and that carried right through into 2024. If we look back over the last couple of years, the US economy has managed to grow at almost 3%. That's actually above its long run average growth trend, and frankly, I think most of Wall Street and many economic forecasters have just caught flat footed and quite surprised by how resilient the US economy has been throughout this piece, throughout these relatively high interest rates, throughout the relatively high inflation that we've dealt with, the US economy has actually managed to grow above average for the last couple of years.

Now, there are a number of special factors involved there, but I think the most important has been just how strong the US consumer has been. I mean, there were a lot of questions over the US consumer coming out of the pandemic, how well they'd be able to manage with the high inflation and high interest rates that we saw on the one side, but on the other side, they were coming out with a lot of pent-up demand and high excess savings, and there's no question that the pent-up demand and high excess savings won the day and led to better than average growth.

Now looking into 2025, we do see things cooling. Some of the factors that boosted the US economy will fade, one of which we don't see the consumer being quite as strong as they've been in the last couple of years.

On the other side, as I said at the outset, we actually do have some relatively pro-growth policies that Mr. Trump has talked about including the possibility of tax cuts. So we've actually nudged up our US economic forecast a little bit for 2025 to 2.2%. Again, that's a little bit below where we've been in the last couple of years, but it's about in line with the long run average, if not a little bit above.

In Canada, it's been a very different story. We have not done better than expected. We have not grown above average. The Canadian economy has struggled to even grow by 1% per year in the last couple of years. That's definitely below average. It's not a recession, but it's well below average. And the big difference between Canada and the US, it really does boil down to the consumer. We are one of the most interest sensitive economies in the world because our relatively high levels of household debt and how quickly that debt turns over.

But I guess the good news there is as we look into 2025, that interest sensitivity cuts both ways just as it has weighed on the Canadian economy for the last couple of years. With interest rates now coming down quite dramatically, we think that a great weight will be lifted off of the Canadian consumer in the next year or two, and we actually see the Canadian economy somewhat strengthening over the next year, and we see the gap closing with the US. So that huge difference between Canada and the US we've seen over the last couple of years, we actually see that gap narrowing and see Canada growing closer to its long-run average as we move into 2025, which is just a little bit below 2% growth. And again, I would stress all these numbers are after inflation or so-called real growth.

Even with that relative improvement we see in Canada, there's no question that Canada has underperformed the US very much. Real GDP per person or you can think of it as income, real income per person, we have badly trailed behind the US over the last 10 years, especially, as I said, on a per person basis. Now some of that's what's been going on through the denominator. The very strong population growth we've seen in the last couple of years, Canada's population growth has exploded at about a 3% pace in each of the past two years. That's not a record high, but it's one of the fastest growth rates we've seen in many, many decades. Now, I think in itself it's a very big economic story that the federal government has abruptly changed its immigration policy and we're going to see a couple years of near zero population growth if they stick to their targets over the next couple years. The way I would interpret that is not a fundamental change in immigration policy, more just a correction to somewhat of an excessive population growth we've seen in the last couple years.

If you smooth out population growth over the past couple years combined with what they're looking for in the next couple years, we end up with overall population growth of about 1.5%, which is actually quite close, if not even still a little bit above its the longer run average. So yes, it will feel very different in the next couple of years, but from a bigger picture lens, as I said, this really just corrects the very strong population growth that we've seen in the past two years.

One reason why the federal government has changed so abruptly is we have seen some upward pressure on the unemployment rate. The very strong population growth has shown up in the labor market. We've actually had pretty decent job growth in Canada over the last year in percentage terms, Canadian employment growth has actually matched that of the US. But because we've had so much stronger population and labor force growth, it's put much more pressure on our job market.

We've seen the unemployment rate rise quite notably over the past year to about six and a half percent, whereas in the US, while it's nudged up a bit, it's considerably lower in the US at just a little bit above 4%. Now the two aren't measured exactly. To correct for differences in measurement, you actually have to take off about a percentage point from Canada's unemployment rate to get it on a US basis, but it still tells that Canada's job market is notably weaker than that in the US. The good news is in the last couple months we've actually seen Canada's unemployment rate flat note at 6.5%.

Looking ahead with much slower population growth and a little bit of a pickup in the growth rate over the next year, the economic growth rate, we think this steep deterioration in the job market that we've seen over the past year will give way to somewhat better conditions by late 2025. We do have the unemployment rate still pushing up towards 7% before it peaks out, but then we look for it to start to moderate as we move through 2025. So in other words, we think we're almost past the worst point for the job market, and there are reasons to be somewhat more optimistic as we move into 2025. Just to point to one silver lining of this relatively sluggish growth that we've seen in Canada, the higher unemployment, is that we've actually had a better inflation performance than much of the rest of the world. Historically speaking, there usually isn't that much to separate between Canada and the US. In other words, where the US goes not just in terms of growth but also in terms of inflation. Usually where the US goes Canada does tend to follow.

But in recent years pretty consistently, Canada's inflation rate has been below that of the US. Throughout the pandemic each and every year, Canada had somewhat slower inflation than the US did, and that's true even now. Even now, the US's inflation rate is still well above 2%, whereas ours is a little bit below 2% at this point. Among the major industrialized economies, Canada's actually towards the lower end of the spectrum in terms of inflation, and some of that is just reflective of the fact that we have had a somewhat softer economic backdrop, which has helped cut price pressures a little bit more aggressively here in Canada than elsewhere. I don't want to make too big of a point of that. If you stand back, the bigger story is most of the world moved up together on the inflation front through '21 and '22, and most of us have come down more or less together through later '23 and into '24. Looking out into the next year. We're actually relatively encouraged. I will say I've been impressed at how much inflation has come down over the past year.

It's actually been a better performance than I would've anticipated. We actually look for inflation average less than 2% in Canada in 2025, and that's not assuming anything untoward. On the energy price front, we're actually assuming oil prices will actually creep up a bit over the next year. If we're surprised, the low side on that front, we could actually have inflation even lower than our forecast of a bit less than 2% as we look into 2025.

So what does this mean for interest rates? I will tell you that the Bank of Canada has been one of the most aggressive rate cutters in the world, and part of the reason for that is when we dig into some of the details on the inflation front, you can see that pretty much the only thing that's driving inflation now are shelter costs. What's driven inflation in the past 12 months, and pretty much it's anything to do with your house, except the home price itself has gone up a lot.

So things like property taxes, mortgage insurance, rent, and home insurance, all of these things have gone up. They are what's really pushing inflation. Whereas the kind of things that cause inflation during the pandemic or in the immediate aftermath, supply chain issues that led to higher auto prices, higher appliance prices, higher furniture prices, those prices are not going up anymore. They're actually down. You can also think back to the revenge travel that we saw in 2022 when hotel rates shot up and airfare shot up. Both of those things are actually down a little bit in price over the past year. So it's a very different world. Things that used to be driving inflation are no longer driving inflation.

And in fact, if we take all the measures of shelter out, you end up with overall inflation of close to zero in Canada and the Bank of Canada is well aware of that. In terms of what this means for interest rates, the Bank of Canada, because they see next to no inflation excluding shelter components, this is one of the reasons why the Bank of Canada has been the most aggressive interest rate cutter in the world.

Just since June, they've cut rates by one and a quarter percent. We do see another cut at their final interest rate decision in December. There's still a debate whether it'll be a quarter or a half. The market's leaning slightly to a half point cut at this moment. We do see a series of cuts though right from here through to the middle of next year, which will take the overnight interest rate from three and three-quarter percent now down to two and a half percent by the middle part of next year. And if we're going to be wrong on that call, it's that the Bank of Canada will be even more aggressive in terms of their rate cuts. In other words, they could go a little bit faster than what we've got in there and they could go a little bit deeper, ultimately. The one thing holding them back or one thing that is holding them back is the Fed is clearly not nearly as aggressive as the Bank of Canada.

We just heard from the Fed last week, and after an initial half point cut back in September, they reeled it back to just a quarter point cut, and clearly the Fed is just not in the same kind of urgency that the Bank of Canada is to get rates down. Unemployment is lower in the US, inflation is higher, and growth has been stronger. So the Federal Reserve just does not have the same kind of urgency that the Bank of Canada does. So while we do see the Fed cutting rates over the next year, we think that they will be much more cautious. So the obvious question is, well, what does that mean for the Canadian dollar?

We have seen the Canadian dollar under sustain downward pressure. It's dropped below 72 cents. That's close to its lowest level in the past 20 years. There's no mystery here as to why it's so weak. We have seen the Bank of Canada diverge quite a bit from the Fed. This clearly put a lot of pressure on the Canadian dollar. The US dollar itself is generally strong against most currencies, but it's especially strong against the Canadian dollar because of this big interest differential. Looking into the next year, as I said at the outset, we do think that Mr. Trump's policies do tend to somewhat favor a somewhat firmer US dollar, but we do think that there are other forces that will gradually work against the US dollar, which we view as being a little bit overvalued at this point, and one of them is we do think the Fed will continue to grind interest rates lower over the next year. So on balance, while we think the Canadian dollar will remain on the defensive in the next few months, as we move through 2025, we do see it stabilizing and mildly improving.

But I do think the bigger picture here for the Canadian dollar is that it is dealing with a pretty serious competitiveness issue, and we are likely looking at somewhat lower Canadian interest rates than US interest rates through 2025, and that's going to keep the Canadian dollar somewhat on the defensive.

One thing to be slightly, I guess, positive on the Canadian economical look, and then the Canadian dollar as we look further into the future, one thing I will tell you is that Canadian government finances generally are in a much healthier position than the US. If we just look at the federal government alone, Ottawa's budget deficit will be between one to 2% of GDP this year. The finances that Mr. Trump inherits, he's starting off with a US budget deficit that's more than 6% of the US economy. That is a very large budget deficit, and most of his proposals would actually boost the budget deficit even above and beyond what we're already looking at.

While that won't have a short-run impact on the Canadian dollar, I think longer term, that big difference in the fiscal landscape will be somewhat supportive of the Canadian dollar, simply because we won't be faced with the need down the road to rein in our budget deficit. In other words, increased taxes or cut spending to dramatically rein in that deficit, whereas the US will face at some point a much more challenging fiscal landscape further down the road. That's it for the very big picture. Thank you.

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