Yikes! - Q3 Real GDP Growth = 0.4%

We knew it was going to be far worse than what the Bank or Bay Street was forecasting, but I still expected growth to come in around 1% for the third quarter. Imports subtracted over 2% from growth and businesses have still refrained from significantly adding to inventories.

Real GDP growth for Q2 was revised up ever so slightly from -3.4 to -3.1.

With such slim growth, there is a good chance that Q3 may be revised into negative territory, indicating that the recession did not end in early Q3 as previously believed.

The Training Wheels Economy rolls on

Don’t get me wrong, it’s great that the economy managed to produce 31,000 jobs last month – however, I find it a little hard to shout recovery from the roof-tops when nearly all of the employment gains were from public sector jobs and “self-employment”. Moreover, the fall in the unemployment rate, from 8.7% to 8.4% had just as much to do with the 25,000 people leaving the labour force in September (is this a back to school effect?). The market seemed to agree with my assessment. The TSX welcomed the jobs report by falling 50 points.

All in all, the data released this week continues to point to a modest recovery in Q3 and an economy that would be continuing to slide if not for extraordinary government support.

The recovery is not off to a good start

A few weeks ago Canadian forecasters convinced themselves that growth in the 3rd Quarter was going to be much better than expected. Unfortunately, the data doesn't seem to be cooperating. Retail Sales for July actually fell 0.6%, and real GDP growth in July was flat, with the retail and construction industries posting declines. This may be a concern given that personal consumption expenditures and residential construction tend to be early indicators of recovery - as shown in this chart from Calculated Risk:



We should get a better idea of the shape of the recovery this week with data for Q3 housing starts, building permits, jobs, and the increasingly important BoC Senior Loan offers Survey all being released in the next few days.

My own forecast for Q3 growth is still somewhere around 1-1.5%. Consensus from Bay Street seems to be around 2-2.5%, though I notice that BMO has, again (aside: I think BMO revises every week, it's really something) revised their forecast to 1.3%.

The Training Wheels Economy

Looking at the most recent National Accounts data from Statistics Canada provides a sense that the Canadian economy can’t quite stay upright on its own. Luckily, the Government and the Bank of Canada have committed to stabilizing the economy until it can, sort of like a set of training wheels on a bike.

For its part, the Bank of Canada has committed to keeping its target rate at an effective lower bound of 25bps until the second quarter of 2010. The fiscal stimulus proposed by the Federal Government is projected by the Bank of Canada to contribute about 2.3% to GDP over the next year and a half, including close to half of the Bank’s projected growth for 2010.

So how long might the economy need training wheels? Well, personal consumption and residential investment seem to have turned, which is normally the case at the end of a recession. However, if this recession is anything like the past, private sector investment in non-residential structures and machinery and equipment may not recover for a while, particularly if bank lending remains tight.





Non-residential investment in structures and M&E contributed an average of about 1% to annual real GDP growth from 2003-2007 before subtracting growth in 2008 and 2009. The fiscal stimulus should go a long way in replacing that growth in 2010, but if consumption growth stalls or the loonie creates a larger than expected drag on exports, we could be looking at keeping the training wheels on for an extended period. If not, a 1980-1982 style double-dip recession is a real possibility.

Canadian Economy contracts 3.4% in Q4 2008

No surprise here, growth was a little worse than my initial forecast(guess) of -2.7%. The economy is now being hit from all sides - both domestic demand and trade were down and household spending was down 0.8%, the first decline since 1995.

Ugh. Next quarter will be much worse and Q2 won't be anything to cheer about either. Hope to see some sign of recovery in Q3. Wake me up when its over.

How to get out of a liquidity trap?

Given the high probability that the Bank of Canada will inch ever closer to the zero bound when it cuts its overnight rate Tuesday, it may be a good time to ask – just how the hell do we get out of this? Here is an non-exhaustive list of ideas:

• Credible adherence to an inflation or price level target – if credible, an inflation target anchors expectations so that a bad equilibrium of unacceptably low inflation or deflation is less likely (this deserves a post of its own, but not right now).

• Assuming fiscal policy is non-Ricardian, the Government could promise to run huge fiscal deficits if inflation falls below a certain threshold.

• Central Bank open market operations in the market for long-term bonds – Goodfriend (2000) argues that such purchases could substantially increase monetary liquidity and therefore inflation expectations.

Given the above list, it would seem that Canada is well placed to get itself out of the liquidity trap. The Bank of Canada has a credible inflation target and therefore much of the work in anchoring inflation expectations has already been done. Moreover, the government has committed itself to running deficits for at least two years, and the Bank has recently announced that it will begin accepting corporate bonds as collateral in its repo arrangements, although this program is largely targeted at reducing spreads rather than altering expectations. All in all, I think this should provide Canadians with some optimism about digging ourselves out of this situation.

Why Canadians should be praying for the US stimulus package to work

I had some free time this weekend so I ran a pessimistic scenario for US recovery through my small-scale Canadian economic model. This scenario assumes that the US recession continues to 2009-Q4 and is followed by a very weak recovery in 2010. The implications for the Canadian economy are pictured below as deviations of Real GDP from its peak in 2008-Q3.



Lets hope it works!

Canada in the Financial Crisis

Carmen Reinhart and Kenneth Rogoff recently published a short paper comparing the path of five US variables in the current financial crisis with the average performance of the same variables during five major crises in other countries - Spain (1977), Norway (1987), Finland (1991), Sweden (1991) and Japan (1992). The five variables chosen were asset prices (real home and equity prices), real economic growth, the current account and public debt. The authors set the crisis year to time "t" and track the variables for 4 years prior (t-4) and 3 years post-crisis (t+3).

I enjoyed this approach so much that I thought I would steal it and apply it to Canadian variables. The graphs that follow use 2007 as the base year for the financial crisis. Unfortunately, I don't have the Reinhart and Rogoff data set so the only comparison I'm able to show is with the US.

(Click to Enlarge)























The results are pretty interesting. Canadian asset prices seem to be following the same path as the United States ( my chart doesn't show it, but Canadian home prices softened in 2008 and should fall in 2009). Also, real growth is declining rapidly.

A key difference between Canada and the US, and perhaps a difference that will have meaningful implications for longer-term recovery, is that at the time the crisis hit, Canada had a much stronger budget and trade balance. Yes, public debt will grow as a result of the stimulus package and yes our trade balance is suffering as Canada's terms of trade weakens but the point is that Canada was in much better shape to withstand the crisis.

In crude terms, we could afford the crisis whereas the United States, partially because of reckless fiscal policy and partially due to a savings glut, could not and will now find it much harder to claw its way back. The lesson, and contrary to the immortal words of Dick Cheney, deficits matter.

More proof that things are really, really bad

Canadian job losses reached 129,000 in January, sending the National unemployment rate to 7.2% from 6.6% in December. Over 100,000 of the job losses were in manufacturing and 71,000 were lost in Ontario alone. My home Province of BC lost 35,000 jobs and the unemployment rate here now stands at 6.1% - up almost two full points from the end of 2007. Alberta continues to hang on to its jobs - I'm not sure how long that can last.

Payroll employment showed employment fell by close to 600,000 - unemployment now stands at 7.6%. Job losses since the start of the recession in December 2007 total 3.6 million. Wow.

Perhaps now that strange breed of creatures known as "Republicans" will feel a little more urgency to pass the stimulus package - that is, if , you know, they can get past the bizarro land logic that "spending" is mutually exclusive with "stimulus".

-0.7% Real GDP in November

Ouch. Before the November release I had Q4 2008 coming in at around -2.4%. I think that forecast is probably still going to be about in line with the actual Q4, though maybe more reflective of the low-end of a range of -2.4% to -3.0%.

I was surprised by the better than expected Q4 GDP in the US (if you can put a positive spin on the biggest contraction since 1982). Real GDP came in at -3.8% vs expectations of -5.8%. Barry Ritholtz points out that much of the upside surprise came from higher than expected inventories. Higher inventories in Q4 should mean production cuts shifting into 2009 and therefore even weaker growth in Q1.

Not good times - bad times.

I'm hoping to post a revised Canadian forecast later today to reflect the released budget and incoming Q4 data. Stay tuned.

Consensus Forecasts: Bloggers vs. Bay Street

As a follow up to the Great Canadian EconoBlog Forecast contest, I thought it would be interesting to compare the opinions of Canadian economics bloggers with the pros on Bay Street. The charts below compare the mean forecast and range of forecasts for 4 of the macro-variables in the contest made by Bloggers and Bay Street (I didn't have time to gather TSX forecasts from the Banks). The sample includes TD, CIBC, Scotia, RBC, and BMO (apologies to National Bank, I couldn't find updated forecasts on your website). The sample of bloggers includes myself, Nick and Stephen from Worthwhile Canadian Initiative, Mike Moffat, and Andrew from Stackelberg Follower. I know others made forecasts but if I couldn't see a link to a blog, you weren't included.



It is interesting that the variable that is the hardest to forecast, the exchange rate, has an appropriately large range (78 cents to 94 cents) and that this range is almost identical between groups of forecasters. Moreover, the Banks would seem to be slightly more bullish on growth, hence the BoC target close to 1%, than the bloggers consensus of only about 0.5%. Other than that, it is generally agreed that inflation will be too low and unemployment too high.

Canadian Econoblogosphere Forecasting Contest 2009

The fellas over at Worthwhile Canadian Initiative have thrown down the proverbial gauntlet - here are the rules:

1. Unconditional point-forecasts only, for 5 macroeconomic variables: CPI, Unemployment Rate, US/CAN Exchange Rate, BoC Target, TSX (My forecasts are the product of a small-scale model so I'll throw in a real GDP forecast as well).
2. Only those who have made a forecast will be allowed to laugh at others' forecasts in January 2010.
3. No prize for the best forecast (other than bragging rights).
4. "Best" forecast is defined as that which minimises the following loss function:
Loss = sum of absolute value of [(forecast-actual)/latest available end of 2008 actual].

Here is what I think is in store for 2009:

CPI Inflation: 0.6%
Unemployment Rate: 7.1%
US/CAN Exchange Rate: 94 cents (with bias downward)
BoC Target: 0.75% (just to be different)
TSX: 8780
Real GDP Growth: -1.7%

That was fun, great idea guys!

Flaherty/Carney vs. Bankers

As discussed previously, Jim Flaherty and Marc Carney will be meeting with Canada's major banks to discuss tight credit conditions. Flaherty/Carney contend that the Banks have more than enough capital to satisfy risk management requirements and therefore should be lending more in order to stimulate the economy. The Banks in turn argue that they are already lending at a prudent level and that tight global credit conditions and elevated default risk are to blame for lower loan volume and the higher cost of capital.

What does the data say? Let's have a stroll through the weeds.

The table below shows the year-over-year change in loans to individuals from table C7 of the Bank of Canada's Banking and Financial Statistics:

		Loans to Individuals
		to purchase securities	autos	renovations	total
2007	I	5%	5%	12%	9%
	II	6%	4%	12%	9%
	III	8%	5%	15%	9%
	IV	1%	7%	17%	13%
2008	I	0%	8%	20%	15%
	II	1%	10%	24%	15%
	III	1%	26%	30%	16%

Thus far, personal loans have continued to increase, at least through the third quarter. I would guess that auto loans and borrowing for renovations will fall off in Q4 2008, but clearly banks are not withholding credit from households.

On the other hand, private business lending has fallen year-over-year by about 2%. Not too dramatic considering tight credit conditions throughout 2008. The table below shows lending activity to some important Canadian sectors:

		Loans to Canadian Businesses
		Financial	Mining	Energy	Forestry	Const.	Mfg	Total
2007	I	28%	128%	41%	-13%	18%	-3%	17%
	II	37%	172%	50%	-12%	15%	1%	13%
	III	33%	65%	38%	-10%	16%	-6%	14%
	IV	83%	9%	21%	-7%	20%	-2%	14%
2008	I	35%	12%	0%	0%	19%	0%	12%
	II	23%	-6%	-28%	-8%	18%	-5%	4%
	III	7%	-14%	-17%	-8%	13%	-6%	-2%

Not surprisingly, lending to commodity producers fell dramatically in the second half of 2008 and lending to weak, over-leveraged, or disappearing manufacturing and forestry sectors continued to decline. Construction and real estate development loans were strong until the third quarter, but I would expect lending to that sector to slow in Q4 and into 2009.

So who does the data side with in this argument? I'd certainly like to see the Q4 data, but absent that, it seems that the banks are already lending where they should, and cutting back in sectors where there is enhanced default risk due to a deteriorating economy.

Until I hear a better articulated argument from either the BoC Governor or the Finance Minister, I'll side with the Banks.

Should the rest of Canada care if the the Big 3 fail?

The Ontario Manufacturing Council (OMC) released a report yesterday (completed by the Centre for Spatial Economics) that showed that the complete failure of the Big 3 in Ontario would mean the loss of about 580,000 jobs in five years. A 50% reduction in Big 3 output would translate to approximately 300,000 jobs lost. Now, while the OMC and the Ontario Government were careful to stress that these losses would be felt across Canada, the report shows that 90% of the job losses would occur in Ontario alone.

That Ontario could lose over half a million jobs in one of its most important industries and the Canada wide effects would be only 60,000 jobs lost over 5 years seems incredible. Moreover, the 580,000 number is the high-end of the estimate and from what I can tell, that scenario assumes that foreign car makers do not set-up in Ontario to replace lost domestic production.

So should the rest of us (non-Ontarians) be calling for a bailout or would the failure of the Big 3 merely cap the long downward spiral of Ontario manufacturing? That is, has the rest of Canada decoupled from Ontario? Recent trends in unemployment rates seem to suggest so.


However these trends may be deceiving. A lot of employment in the West has been a product of the commodity boom, and therefore recent trends may represent a cyclical rather than a structural change. Moreover, the economy is in a particularly fragile state and a shock of this magnitude, even if it seems to be localized in Ontario, may have other adverse effects. Hmm...does this mean I've talked myself into an auto-bailout?

Revised BC Forecast

I've been thinking a lot about how BC may be impacted by a Canadian recession and how that impacts my forecast. Here are the relevant facts:

1) Canada is almost certainly going to be in a recession to start 2009. If standard models for the transmission of US shocks to the Canadian economy hold, a 4%-6% decline in US growth could translate to 1.2%-1.8% decline in Canada - on top of softening domestic demand. These shocks should hit BC through inter-provincial and US export channels.

2) According to BC Stats, inter-provincial exports account for about 16% of BC GDP, with most of the trade occurring with Ontario and Alberta. In the 1990 recession, BC exports declined about 2% and in the 1982 recession exports declined close to 11%.

3) International exports account for 28% of BC GDP. In the last US recession, these exports fell 5%. Moreover, key BC export sectors - mining and forestry - are in serious trouble.

This all sounds really awful - perhaps too awful to produce 1.3-1.4% growth. Taking the above into consideration, my revised forecast says that without VANOC stimulus, the BC economy would likely slip into a recession, posting growth of -0.2%. With VANOC spending, and its indirect effects, growth should be bumped up by 0.4%-0.5%.

Therefore, the revised forecast is 0.2-0.3% - 2010 saves the day! (just kidding, no hate mail please).

Dr. Taylor’s Monetary Tonic

A Taylor rule ( named for John Taylor of Stanford) is a somewhat mechanical rule for monetary policy that suggests that an optimal policy should minimize the variation of inflation around its target and output around its potential. Its general specification is:

r =r* + β(π- π*) + γ(y – y*), where values with a *are steady-state or target values.

Even though the Bank of Canada is mandated solely to keep inflation near its target of 2%, it is not surprising that it responds to an output gap as well since an economy growing above potential is inflationary. An estimated rule reveals weights on the inflation and output gap of 1.88 and 0.38 – awfully close to the values of 2 and 0.5 suggested here: http://www.bankofcanada.ca/en/res/wp/2002/wp02-1.pdf. These estimates show a much heavier weight on excess inflation than on output, about what we should expect from an inflation targeting central bank.

Taylor rule for the target rate tracks the average quarterly overnight rate fairly closely, though suggests that the Bank should have started cutting earlier and more aggressively

UPDATE- Nick Rowe asks where the broken line comes from in the above graph - It represents my forecast (guess) at the future path of the output gap and inflation. Needless to say, i'm expecting inflation to not be a problem and for growth to disappoint to the downside. I've also added a second red broken line to show the Taylor rule path for the overnight rate based on the current BoC forecast (MP from Oct. 23). Thanks Nick.

r = r* + β(π- π*) + γ(y – y*), where values with a * are steady-state or target values.

Even though the Bank of Canada is mandated solely to keep inflation near its target of 2%, it is not surprising that it responds to an output gap as well since an economy growing above potential is inflationary. An estimated Taylor rule reveals weights on the inflation and output gap of 1.88 and 0.38 – awfully close to the values of 2 and 0.5 suggested here: http://www.bankofcanada.ca/en/res/wp/2002/wp02-1.pdf. These estimates show a much heavier weight on excess inflation than on output, about what we should expect from an inflation targeting central bank.

A Taylor rule for the BoC target rate tracks the average quarterly overnight rate fairly closely, though suggests that the Bank should have started cutting earlier and more aggressively.

UPDATE- Nick Rowe asks where the broken line comes from in the above graph - It represents my forecast (guess) at the future path of the output gap and inflation. Needless to say, i'm expecting inflation to not be a problem and for growth to disappoint to the downside. I've also added a second red broken line to show the Taylor rule path for the overnight rate based on the current BoC forecast (MP from Oct. 23). Thanks Nick.

This is totally going on my blog...

First a note about this blog: As the subtitle implies, I've started this blog in the hope that it will act as a device to flesh out and organize my own ideas about economics and to aid in learning some new tricks. Doing so with an audience, even if that audience is limited to my wife and bored friends and family, will help provide some discipline. Second, there is a paucity of quality Canadian economics blogs. One is the excellent Worthwhile Canadian Initiative, I can't think of any others. My hope is to approach their level of quality, but I expect to fall woefully short.

What you can expect to find here - macroeconomic analysis of the Canadian and US economies. I'm hoping to start a forecast log to keep track of my own predictions, but that project is still under development. My interests are mainly monetary policy, exchange rates and financial markets, and so that is likely what i'll be posting about.

Lastly, I realize the best blogs are ones that have frequent new material and so I'll do my best to post as often as possible.

On with the show!