Canada

OECD Economic Outlook, Dec, 1996

The present economic situation

The period of slower growth that followed upon the spurt in activity in 1994 continued into 1996. Economic expansion in the first half of the year - 1 1/4 per cent at an annual rate - was limited by a sharp inventory correction, which reduced real GDP growth by 1 3/4 [TABULAR DATA OMITTED] percentage points. Indeed, while companies had adjusted excess inventories only gradually to slowing demand during 1995, possibly in the expectation that stronger growth would eventually correct stock/output ratios, they apparently deemed inventory levels uncomfortably high, as profits came under pressure. In contrast to the weak output growth in the first half of 1996, final domestic demand - which had virtually stagnated during 1995 - picked up markedly in response to declining interest rates. Housing investment, in particular, recovered strongly, but households' current spending also strengthened significantly. Exports rebounded after the resolution of labour conflicts, which depressed their growth rate in the first half of 1996.

Following the inventory correction, output growth has begun to reflect more closely underlying demand trends. This has induced businesses to step up job creation with gains concentrated in industries whose demand is sensitive to interest rates (notably construction and manufacturing). However, given the decline in public sector employment and a marked pick-up in labour-force growth, job creation in the private sector has not sufficed to reduce unemployment which - at 9 1/2 to 10 per cent has remained well above its structural rate (put by the OECD Secretariat at around 8 1/2 per cent). Such slack in [TABULAR DATA OMITTED] the labour market, together with a widening of the output gap (to around 3 per cent according to the OECD Secretariat estimate) has contributed to keep inflation within the lower part of the official 1 to 3 per cent target band, with the Bank of Canada's measure of core inflation running at 1 1/4 per cent in recent months. Favourable price performance has consolidated the substantial gains in Canada's international competitiveness from exchange rate depreciation in 1992-94. Along with slower import growth, this has contributed to a marked improvement in the external current account, which has moved into surplus for the first time since 1984.

Policies and other forces acting

Over the past year or so, a number of developments have increased financial-market confidence, thus providing an environment favourable to an easing of monetary conditions: as noted, inflation has moved back into the lower half of the target range; a great deal of progress has been made by all levels of government in reducing budget deficits; the current account has moved [TABULAR DATA OMITTED] into surplus; and political uncertainty has diminished since the Quebec referendum on sovereignty. All these factors have contributed to a more stable Canadian dollar, and with short-term exchange rate volatility declining, financial markets have been able to focus on the fact that fundamentals had warranted significant monetary easing for some time. This has allowed the Bank of Canada to lower short-term interest rates to levels well below those prevailing in the United States. Latest reductions in the Bank's target for the overnight financing rate - to a range of 2 3/4 to 3 1/4 per cent - have brought official rate cuts to 5 percentage points in just under 1 1/2 years. Low money market rates have pulled down yields all along the curve, with Canadian rates, as of mid-November, below US rates for maturities of up to ten years. Long-term interest differentials (over ten years) have also come down to just under 30 basis points, the lowest spread since mid-1984. OECD Secretariat projections assume that fundamentals will allow the Bank not to follow an eventual modest increase in short-term rates in the United States and lead to a further decline in the, and eventually a negative, differential between Canadian and US long-term rates.

[TABULAR DATA OMITTED]

Fiscal developments should help in this respect. In stark contrast to the early 1990s, recent budget deficit reduction targets have consistently been met or exceeded, which has boosted the credibility of government fiscal planning. The general government deficit (national accounts definition) has declined from a peak of 8 per cent of GDP in mid-1993 to below 3 per cent [ILLUSTRATION OMITTED], with cyclical factors accounting for less than one-third of this improvement. A common feature of both federal and provincial consolidation efforts has been the focus on reducing expenditure - rather than raising revenues - an approach which experience in some other OECD countries suggests is more likely to be successful. Canada's recent impressive track record regarding fiscal consolidation has to be seen in perspective, however. On current budget plans, the public debt-to-GDP ratio will start falling only in 1997 and it will take some time before it approaches the OECD average. Moreover, while a majority of provincial budgets are already in surplus, the federal government and the two largest provinces - Ontario and Quebec - have still some way to go before they achieve budget balance, as intended. With fiscal restraint ongoing and the cyclical component of the deficit declining, general government finances (on a national accounts basis) are projected by the OECD Secretariat to approach balance by the end of 1998.