II. Developments in individual OECD countries: Canada

OECD Economic Outlook, June, 2004

The economy accelerated in the last quarter of 2003 as export volumes rebounded and inventories rose, but final domestic demand was weak. With lower import prices and the end of special factors, inflation has fallen below the central bank's target range. Going forward, the expected world trade recovery, together with a strengthening of internal demand, should help output growth return to above its potential rate later this year while inflation should remain subdued.

Given low inflation and doubts as to the strength of the rebound, the Bank of Canada has eased monetary policy three times this year. With planned budgetary restraint, the current policy mix appears appropriate, as long as vigilance is exercised over expenditure. However, the monetary stimulus will need to be withdrawn once robust economic growth is in place. Fiscal policy should continue to focus on maintaining the downward trend in the debt burden before ageing pressures accumulate.

Last year's appreciation of the exchange rate has dampened activity ...

After a series of one-off negative shocks in the course of 2003, activity recovered in the last quarter of the year. However, inventory accumulation in cars and livestock (following the US ban on imports of Canadian beef) played a large part. Despite the impetus provided by the US recovery and higher receipts on the tourism account, imports increased faster than exports, and more recent trade flows suggest that the lagged effects of last year's sharp appreciation continue to depress the tradeables sector in early 2004. Specific factors also affected domestic demand towards the end of last year. Non-residential investment, especially transportation equipment, decelerated, while flat private consumption reflected weaker car purchases. In contrast, residential investment has been growing at a fast rate, spurred in particular by low mortgage rates and high consumer confidence.

... while household income growth has slowed

Employment grew more strongly than output in 2003, but overall household disposable incomes expanded slowly, as increases in compensation per employee and in transfers were modest. Private consumption remained strong, except in the last quarter of 2003, and the household savings ratio fell to a historically low level. Fast growth in retail sales suggests that private consumption regained momentum in early 2004. Employment growth eased at the beginning of 2004, with weakness concentrated in part-time jobs. This, together with continued rise in the participation rate, has meant that the unemployment rate has fallen only slightly and wage settlements have remained moderate. Core consumer price inflation has decelerated markedly over the past year, partly because of falling import prices. Low annual inflation rates in early 2004 also reflected the end of some special factors such as earlier marked increases in auto insurance premiums and lower prices for gasoline and fuel oil than a year ago.

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Monetary policy is currently accommodative ...

Against this background and with the absence of clear signs that activity was rebounding, the Bank of Canada lowered official interest rates in January, March and April 2004 by a total of 75 basis points to 2 per cent. With core inflation well below the mid-point of the target range, there is room to maintain the present monetary stimulus for the time being. But the Bank may need to start increasing rates toward their neutral level if, as expected, a robust expansion materialises during the year, narrowing the existing modest margin of spare capacity.

... and the fiscal policy stance remains neutral

The March 2004 federal budget reflected the government's commitment to achieving balanced budgets or better and paying down public debt. It also introduced a long-term objective of lowering the ratio of federal debt to GDP to 25 per cent within 10 years, to help the economy to deal with ageing pressures. In addition, it incorporated some limited expenditure measures for a number of targeted priorities, including education and health. With the exception of an increase in the capital cost allowance rate for computer equipment and a full Goods and Services Tax rebate for municipalities, no new major tax reductions were announced. Still, a number of tax cuts for both corporations and households came into effect on January 2004, marking the final stage of the 2000 five-year tax reduction plan. Lower interest payments on debt along with a slight fall in the primary surplus would keep the general government surplus at about 1 1/4 per cent of GDP over the projection period.

Output is expected to grow slightly faster than potential in 2004-05 ...

Apart from a correction of the involuntary accumulation of inventories in the first quarter of 2004, GDP growth is expected to be above potential throughout the projection period, with the output gap being closed in mid-2005. A recovery of export demand should be one of the main drivers of the upswing, especially if the