Canada: Bennett Jones Spring 2018 Economic Outlook

Section I: Global Growth to 2020

The outlook for global growth in 2018 and 2019 is now considerably stronger than forecasters anticipated it would be a year ago. Advanced economies are now expected to grow at rates well in excess of potential in both years, eliminating remaining slack in the United States, Europe and Japan. This strong growth is underpinned by accommodative financial conditions, a stronger expansion in many emerging economies, and a large tax and expenditure stimulus in the United States. At the same time, central banks in the advanced economies continue to be cautious in raising interest rates and have indicated their willingness to accommodate above-trend growth as wage and price inflation continues to be benign. Credit conditions will continue to be favourable for continued growth through the end of 2019 even as central banks cautiously raise interest rates. But continued expansion of credit brings with it the collateral risk of rising aggregate debt (household, business and government) that could seriously threaten stability and growth down the road. Thus, both Canadian business and government should keep in mind that the buoyant prospects for global growth over the next two years, growth sustained by accommodative monetary and fiscal policies in the advanced economies, are associated with an increasing risk of a major correction in the 2020s.

Recent Developments

In the advanced economies, real GDP has grown strongly since the end of 2016. The swifter momentum began in the Euro area in the last quarter of 2016, in Japan in the first quarter of 2017 and in the United States in the second quarter of 2017. Above-trend growth has been propelled by increased investment and stronger consumer spending. These have been supported by high levels of business and consumer sentiment and accommodative financial conditions. Moreover, stronger economic activity and higher capacity utilization have had an "accelerator" effect on non-residential business investment. The rapid expansion paused in the first quarter of 2018. Whereas real GDP actually declined in Japan, it still grew significantly faster than potential in the United States and slightly above potential in the Euro area. In both the United States and the Euro area, much of the slowdown in the first quarter was attributed to one-off factors, including unseasonably harsh weather.

Despite accelerating growth and improving labour markets over the last 18 months, inflation in the advanced economies has remained rather subdued. Core inflation in 2018-Q1 was about 1.0% in the Euro area and around 0.0% in Japan, much below target. In the United States, core inflation¹ climbed from about 1.5% in 2017-Q4 to 1.8% in April, close to target. The pace of annual wage gains in the United States, however, continued to be moderate in the first five months of 2018. While the European Central Bank and the Bank of Japan have held their policy interest rates at emergency low levels, the Federal Reserve has continued the process of interest rate normalization as it lifted the target federal funds rate by another quarter percent in December 2017 and again in March 2018, to 1.75% (upper limit).

After a sharp decline from mid-2014 through early 2016, commodity prices staged a fairly steady recovery through to April 2018, which brought them to about three quarters of the average level they reached from early 2012 to mid-2014. West Texas Intermediate (WTI) oil prices, in particular, steadily firmed from a trough of US$45 a barrel in June 2017 to just over US$70 a barrel in May 2018 reflecting stronger global demand and cuts in the supply of the Organization of the Petroleum Exporting Countries (OPEC) oil, both of which reduced ample inventories to below-average levels in spite of increased shale oil production in the United States. The U.S. withdrawal from the nuclear deal with Iran and the economic and political crises in Venezuela also put pressure on oil prices in May. The firming of commodity prices has contributed to improved growth in resource dependent emerging market economies such as Brazil and Russia.

On a trade-weighted basis the U.S. dollar (broad index) has been fairly volatile in the last 18 months. In the last week of May it was 9.0% above its average of the previous 20 years, reflecting in part a 2.0% appreciation during the month. Growth in China has remained remarkably strong and stable over the last five calendar quarters at just above the authorities' target growth rate of 6.5%. While Chinese authorities have taken some steps to moderate house price increases, credit conditions have remained expansionary. Continued strong growth of domestic demand in China and the advanced economies has contributed to synchronized growth in most of the world's economies for the first sustained period since the great financial crisis.

Global Economic Outlook

The synchronized global expansion of 2017 is projected to continue in 2018 and well into 2019. Global growth is expected by the International Monetary Fund (IMF) to come in at about 3.9% in both 2018 and 2019 well above global potential growth of about 3.5%. By 2020, global growth is expected by most forecasters, including the IMF, to slow to about potential.

The main factors contributing to this buoyant short-term outlook are as follows:

• Negative shock of falling commodity prices in 2014–2016 has passed.
• Fiscal policy is less restrictive in most countries and very expansionary in the United States (see next page).
• While central banks will continue to raise policy interest rates, they have all indicated that increases will be gradual and that they are willing to see some period of modestly above-target inflation.
• Business investment growth is expected to continue at a robust pace, buoyed by solid profits and high levels of business confidence and capacity utilization in many countries.
• Household consumption in the advanced economics and China remains robust. High levels of consumer confidence and a strong labour market prevail in many countries.
• WTI oil price is now expected to be above US$65 in 2018 and 2019 on the strength of global demand, but production will probably expand enough (along with some further inventory drawdown) to keep WTI below US$75 on an average annual basis. However, slower growth of the global economy in 2020 will reduce oil demand growth and should prompt a retreat of the price of WTI to around US$60 to US$65. Geopolitical developments, notably regarding Iran, create upside risks to oil prices in the short term and no doubt will contribute to considerable volatility in oil markets.
• Despite protectionist actions by the United States, several observers including the IMF expect international trade to expand somewhat faster than domestic demand, thus enhancing global growth as international trade did in most years prior to the great financial crisis. The projected increase in trade intensity would partly reflect the buoyancy of investment in machinery and equipment, which has a relatively high import content.

In the short run we expect positive factors to contribute to above-trend global growth despite the immediate geopolitical uncertainties. While there may be significant downside risks to growth in the early 2020s as we outline in the "Risks" section, we believe our base-case projection of prospects for global growth (Table 1) provides a sound planning basis for Canadian business and governments.

Base-Case Projection

Our base-case projection for global growth of 3.8% in 2018 and 2019 is considerably higher than the 3.5% we projected last fall. This upgrade mostly arises from much stronger growth in the United States as we explain below. Growth in the Euro area is also expected to be a little stronger while growth in China remains as strong as projected last fall.

Table 1: Short-Term Prospects for Output Growth (%)*

* Figures in brackets are from the Bennett Jones Fall 2017 Economic Outlook.
¹ Weighted average of Canada, United States, Euro area and Japan.

Before tax cuts and spending legislation was passed around the end of 2017, we projected in our Bennett Jones Fall 2017 Economic Outlook an above-trend growth rate for the United States of slightly more than 2.0% for 2018 and 2019. This above-trend performance was predicated on elevated consumer confidence, strong labour market, accommodative financial conditions, and strengthening investment. All these factors still underpin the above-trend U.S. growth rates currently projected in 2018 and 2019. In addition, the U.S. tax and spending policy changes that were introduced around year-end are expected to have a far larger effect in the short-term than we anticipated last fall. Moreover, we observe that consumer confidence and business confidence in the United States are nearing historical peaks and that proposed relaxation of restrictive financial regulation will contribute to easier credit conditions. We would expect domestic spending to show more strength than otherwise because of these two factors.

Faced with prospects for stronger growth and hence greater inflationary pressures, the Federal Reserve is expected to raise its policy rate to a higher level (3.0% to 3.5%) by the end of 2019 than we anticipated last year at this time. This additional withdrawal of monetary stimulus, along with a likely positive effect on the U.S. dollar exchange rate, would offset some of the stimulus from tax cuts and spending increases by 2019 and 2020.²

The combination of all the above factors has caused us to increase our projections of U.S. growth rates by 0.6 percentage points to 2.9% for 2018 and 0.6 percentage points to 2.6% for 2019. The stimulative impact fades to 0.2 percentage points by 2020. In the absence of a geopolitical shock or unexpected burst of inflation, growth in 2020 is projected to be 2.0%, a rate consistent with a somewhat stronger potential growth than before. While we are not quite as bullish as the IMF on U.S. growth in the short run, we have substantially increased our projected growth rate as illustrated in Table 2 below.

Table 2: U.S. Real GDP Growth (%)

The first important fiscal change in the United States enacted late last year is the Tax Cut and Jobs Act (TCJA) (line 2, Table 2). Many studies produced estimates of the macroeconomic impact of the TCJA over the next decade. Our judgment is that the estimates produced by the Congressional Budget Office (CBO) in April³ provide the most realistic picture of the macroeconomic impact of the TCJA over the coming decade. Based on these estimates, we expect the TCJA to boost growth by 0.3 percentage points each in 2018 and 2019 and by 0.2 percentage points in 2020. For a more detailed description of TCJA and analysis of its macroeconomic effects, please see Annex 1 at the end of this section.

The second important fiscal change in the United States arises from spending increases in the Bipartisan Budget Act, 2018 (BBA) and the Consolidated Appropriations Act, 2018 (CCA). These acts increase federal spending authority in 2018 and 2019 by US$150 billion (0.7% of GDP) each year. Based on CBO estimates of their impact on the level of real GDP, we expect these measures to boost growth by 0.3 percentage points in 2018 and 0.4 percentage points in 2019 (line 3). We assume that the higher level of federal spending will be maintained in 2020 and therefore will have no additional effect on growth in that year.

The Trump administration has also introduced regulatory changes which have favoured increased business investment⁴ and will effectively ease credit conditions going forward (line 4). At the same time it has created much uncertainty about its future protectionist trade actions and the retaliatory response of trading partners. While it is very difficult to estimate the total impact that these three changes will have on growth, we judge that a net improvement in business sentiment will lead to higher investment and contribute about 0.1 percentage points of additional annual growth over the next three years.

As a result of all these changes, we and most analysts expect the Federal Reserve to raise its policy interest rate somewhat faster than anticipated before. Indeed, the Federal Reserve revised upwards the projection of its policy rate over 2018-20 at its March 2018 meeting. We project the additional rise in interest rates and its possible boost to the U.S. dollar exchange rate to subtract 0.1 percentage points from growth in 2019 and 2020 (line 5). Our projection of the U.S. policy rate is close to that of the Federal Reserve: we anticipate that the Federal Funds rate (upper limit) will be raised to 2.25 to 2.5% by the end of 2018 and to 3.0% to 3.5% by the end of 2019 or early 2020. The Federal Reserve projects that a rate only slightly above their 2.9% estimate of the "neutral rate" will be necessary to maintain inflation roughly at 2.0% over the next couple of years. Should much stronger excess demand emerge— as the IMF thinks might be the case—then the Federal Reserve might have to move rates up faster and further. However, since the Federal Reserve's projected growth is closer to our projection than to the IMF projection, we think that Canadian businesses and governments should do their planning based on an expected increase of the Federal funds rate to about 3.25% by early 2020 and on the basis that the yield on 10-year U.S. treasury bonds will reach about 3.5%.

We expect part of the slowdown in the Euro area in 2018-Q1 to be the result of one-off factors and project growth there to be above trend in the short term. As excess capacity diminishes and monetary policy gradually becomes less accommodative the pace of growth will slow from 2.5% in 2017 to 2.2% in 2018, 2.0% in 2019 and 1.7% in 2020 compared with a trend growth rate of close to 1.5%. This strong performance will be supported by high confidence levels, accommodative financial conditions, and robust growth in world trade and activity. The expansionary effects of fiscal policy changes in the United States will contribute to the latter. On the other hand, the appreciation of the Euro against a basket of currencies in the last year is expected to moderate net export growth for a little while. This being said, the Euro-U.S. dollar exchange rate started depreciating in mid-April and will probably continue to do so on average in the rest of 2018 and most of 2019 as the United States will likely experience widening positive differentials in economic growth and interest rates relative to the Euro area over this period. As with regards to fiscal policy in the Euro area, it is projected to be neutral to slightly restrictive over 2018-20.

Despite weakness in the first quarter this year, growth in Japan is set to be above trend in the short term as robust consumer confidence, strong profits and rapid global growth support significant expansion of domestic demand and exports. Growth in 2018 and 2019 is now projected to be a bit stronger than last fall. A planned hike in the value-added tax in 2019 will slow growth significantly in 2020.

China is expected to continue to pursue policies that will allow real GDP to grow at rates consistent with its earlier 6.5% target but allowing for a gradual slowing in the short term in order to pursue "quality instead of speed" in keeping with the priority given at the 19th Congress on economic transformation (including rebalancing) and sustainable growth. We assume that there will be no major disruption of trade with the United States (see Section II on trade) and expect that the Chinese authorities will keep the yuan exchange rate close to its recent level of 6.3 yuan per U.S. dollar in the short term. The IMF expects nonfinancial debt to rise further as a share of GDP, increasing risks for financial stability and growth in the medium term.

Risk to the Short-Term Outlook

Aside from the heightened geopolitical risks of turmoil involving Iran and the Middle East or more overt conflict between Russia and the west, the main negative economic risk to the strong projected global growth of 3.8% in 2018 and in 2019 relates to protectionist trade actions by the United States and potential retaliatory actions by others. One reputable analyst estimates that in the worst case "a global trade war, though still unlikely, would administer a negative shock to world GDP of perhaps 1 to 3 percentage points in the next few years."⁵ Trade risk is discussed in detail in the next section of this outlook.

We think that over the next two years the risks to global growth arising from major changes in projected monetary and fiscal policies of governments in the United States, Europe or China are fairly limited. More specifically, as we consider that a strong burst of U.S. inflation has a low probability of occurring in the short term, we think the risk of interest rates being significantly higher than projected is low. While the stimulative impact of the recent fiscal policy changes in the United States may turn out to be modestly larger or smaller than currently projected, the risk of a significantly different policy impact on global growth from our current projection is also low.

Finally, we consider that the upside risk that global growth be stronger than we project in the short term is more important than the downside risk that would arise if the unexpectedly subdued growth observed in 2018-Q1 in advanced economies were indicative of a return to lower-trend growth. The risk of higher growth than projected (especially over the next 12 months) arises from the high level of positive business sentiment in the United States, Japan and Europe, which may prompt stronger investment than anticipated. In turn, stronger investment may boost potential output and allow significantly faster demand growth than projected without generating greater inflationary pressure. In that case, global growth could well reach 4.0% in both 2018 and 2019 and could exceed 3.5% in 2020.

Taking all of the above risks into consideration, we believe Canadian businesses and governments should do their planning based on our projection of strong global growth in the order of 3.8% this year and next, slowing to 3.5% in 2020. They should plan for the interest rate on U.S. 10 year treasuries to rise to a peak of 3.5% over this period and for commodity prices to remain in a reasonably favourable range.

Medium-Term Risks

Except for the ever present geopolitical risks and the possibility of a significant disruption to international trade, the risk of a sharp economic slowdown over the next two years is thus fairly low. However, the medium-term risk of an economic disruption is much greater. Favourable credit conditions, optimistic consumer and business sentiment and increased government borrowing by the world's major governments in 2018 and 2019 will likely add substantially to the current high global debt level by the end of 2020. This high and rising level of debt renders the global economy increasingly more vulnerable to an abrupt correction and makes the global financial system much more fragile. The same sort of imbalances we observed in 2005 and 2006 seems to be emerging again. Leverage and risks are building. While the financial sector has stronger buffers than 10 years ago, consumers, businesses and governments in most large economies are leaving themselves less able to absorb economic shocks. Fiscal authorities will have less room to provide stimulus in the next downturn.

With policy interest rates already low, central banks will have less room to provide conventional monetary stimulus to stabilize a faltering economy. Moreover, the projected substantial widening of both budget and current account deficits in the United States raises the risk of higher U.S. real interest rates (to attract capital) and weaker U.S. growth in the medium term, with negative spillovers in the rest of the world, especially emerging economies.

Canadian governments, businesses and individuals should take advantage of the current outlook for strong global growth and still favourable interest rates by investing in productive infrastructure, productivity enhancing research machinery and equipment, and skills upgrading (see Section IV: Taxes, Regulation and Competitiveness). Increasing borrowing to pay for expanded current services, to fund buy backs and higher dividends, or to enjoy greater consumption of goods or services today would make Canada vulnerable to a global economic slowdown, the risk of which increases in the 2020s.

Annex 1: Impact of the U.S. Tax Cut and Jobs Act

This annex is about the macroeconomic impact of the TCJA which took effect on January 1, 2018, i.e., the impact on economic growth and potential economic growth. We summarize expert analysis of the aggregate implications of the TCJA for investment, labour supply and government deficit but not the impact on U.S. businesses and their Canadian subsidiaries at a firm or industry level. We first describe the major changes to the tax system and their theoretical effects, and then provide estimates of these effects essentially based on the detailed analysis done by the U.S. CBO.

The TCJA includes many changes to the tax system which affect both individuals and businesses. Among the changes that are expected to have a bearing on the U.S. macroeconomy, the following are worth noting:

• a permanent cut in the corporate tax rate from 35.0% to 21.0%;
• rate of bonus depreciation raised to 100.0% in 2018, extended for five years through 2022, and then phased out by the end of 2026; depreciation made less generous for R&D and for software development beginning in 2022;
• repeals of or limits on deductions for a number of business expenses, including tighter limits on interest deductibility;
• elimination of the taxation of most foreign corporate income of U.S. corporate shareholders; one-time transition tax on untaxed profits; base erosion measures and effectively a minimum tax on some of the foreign operations of U.S. corporations;
• lowering statutory marginal tax rates for income of individuals, while changing some of the income levels associated with each bracket; eliminating personal exemptions while increasing the standard deduction and the maximum amount of child tax credit; all these changes expire by 2025; and
• permanent change in the measure of inflation for adjusting tax system parameters to a chained Consumer Price Index (CPI) measure which will accelerate bracket creep and hence increase individual tax revenues over time.

The size and time profile of the impact of these measures on U.S. GDP will be the outcome of several factors:

• how much of the reduction in taxes paid by individuals and businesses is ultimately spent on consumption, housing, investment and imports, account taken of the fact that businesses will channel part of their tax savings into share buybacks and dividend payments and that individuals will save rather than spend part of the tax savings and the increased receipts from businesses. This static, budgetary effect raises GDP and, to a lesser extent, potential GDP.⁶ It is worth noting that in dollar terms much of the tax savings will accrue to individuals with higher incomes than average and that, as a result, the growth impact of the tax cuts will be attenuated because higher-income individuals have a higher marginal propensity to save than average;
• whether and when U.S.-based firms, incurring one-time tax on earnings offshore, will in fact patriate the earnings (or leave them offshore) and then invest in the United States or distribute the earnings to shareholders;
• how the cut in effective marginal tax rates for individuals stimulates increased labour supply and how the decrease in the after-tax user cost of capital resulting from lower statutory tax rates and larger bonus depreciation brings additional investment,⁷ including net direct investment from abroad. This two-pronged supply-side effect raises GDP and potential GDP;
• by how much TCJA boosts GDP relative to potential GDP and hence inflationary pressures in the economy, thereby pushing up interest rates and strengthening the exchange rate, with negative effects on GDP;
• how the government, households and firms react to the projected expansion of the public deficit and debt resulting from the tax cuts; if the government eventually undertakes restrictive fiscal measures or if individuals and firms raise their saving rate to cope with an anticipated rise in their future tax liabilities, the negative effect on aggregate demand would offset part of the positive effects of the original tax cuts; and
• how much the debt-to-GDP ratio rises as a result of the fiscal changes and how much this raises long-term interest rates with negative effects on aggregate demand.

Whether the currently temporary provisions of the TCJA will be eventually extended or made permanent is uncertain. Ceteris paribus, this would increase the positive impact on GDP beyond 2025, but at the same time raise the debt-to-GDP ratio even further. In a context of large deficits, the case for making the temporary provisions permanent would exist only if the positive effect of tax cuts on potential GDP were large. Only the next several years will tell whether, in contrast with current expectations, this is a plausible outcome. If the effect is not large enough and yet the measures were to be made permanent anyway, then most likely financial market pressure would lead to fiscal correction measures to contain rising long-term interest rates and/or the private sector would start increasing its precautionary saving. In such circumstances, the net positive effect of the tax cut extension would be considerably diluted, if not completely offset over time.

Methodology and assumptions have a big impact on the estimates of the effects of TCJA. The CBO projects that TCJA would expand the federal deficit by a cumulative $0.7 trillion over 2018-20 and $1.8 trillion over 2018-27, taking into account higher debt-service costs and the positive macroeconomic feedback effects on taxable incomes of individuals and businesses.⁸ By comparison, the corresponding deficit impacts estimated by the bipartisan Joint Committee on Taxation are $0.6 trillion over 2018-20 and $1.1 trillion over 2018-27.⁹ Changes to taxes on individuals constitute the largest source of revenue loss in the short term while changes to taxes on foreign corporate income provide a partial offset by generating additional revenue.

The estimated impact of TCJA on the level of GDP varies considerably across studies, even for the short term. A sample of eight projections show real GDP higher by between 0.3% and 0.9% over 2018-20 and by between -0.1% and 2.9% by 2027. The estimates of the CBO, which are based on sound methodology and reasonable assumptions and have been assembled with great attention to fiscal details, provide a solid basis for judging the impact of TCJA. They show the positive effect of TCJA on the level of real GDP rising from 0.3% in 2018 to a plateau of about 0.9% in 2021-25 before declining to 0.6% by 2027 following the expiration of individual tax cuts and the phasing out of bonus depreciation. In the short term, TCJA would provide a boost to real GDP growth of 0.3 percentage points in 2018, 0.3 percentage points in 2019 and 0.2 percentage points in 2020. These are the estimates on which we have based our projections of U.S. growth.

Chart 1

Sources: CBO, The Budget and Economic Outlook: 2018-2028, April 2018.

The impact on potential GDP would be similar to that on GDP itself over the period, albeit smaller until 2022. The increase in potential GDP stems in part from a rise in labour force participation and hours worked in response to a fall in the average effective marginal tax rate for individuals of about 2.1 percentage points through 2025 and zero afterwards. It also stems from an increase in capital intensity and innovation as investment responds positively to the cut in the effective marginal federal tax rate on capital income. Such a cut is estimated by the CBO to be 1.8 percentage points in 2018, widening to 3.4 percentage points in 2021 before narrowing to 1.5 percentage points by 2027. Investment would also respond, but more modestly, to the increase in economic activity and rise in interest rates induced by TCJA.

As a result of a faster increase in GDP than potential GDP, a larger excess demand in the U.S. economy would persist until 2022, raising inflation and interest rates temporarily and possibly pushing up the external value of the U.S. dollar. The consequent crowding out of U.S. private spending would intensify until 2022 before receding almost completely by 2027.

Footnotes

1. As measured by the year-to-year change in the price index of consumption expenditures excluding food and energy, the measure preferred by the Federal Reserve.
2. The Federal Reserve's target policy rate would have to rise to even more than the projected 3.0% to 3.5% in 2019 were it not for a faster projected increase in potential GDP associated with the pick-up in business investment and labour supply resulting from the TCJA (see Chart 1A in Annex 1).
3. Congressional Budget Office, The Budget and Economic Outlook: 2018-2028, April 2018.
4. See Section IV.
5. Gavyn Davies, "The economic damage from a trade war", Financial Times, March 19, 2018.
6. Potential GDP refers to "an economy's capacity to produce goods and services when all available productive resources—specifically, labour and capital—are used to their fullest". See L. Schembri, "The (Mostly) Long and Short of Potential Output", Remarks to Ottawa Economics Association and CFA Society Ottawa, May 16, 2018. Potential GDP depends on the trends in the quantity and quality of capital and labour and in the efficiency of the production process.
7. Note that TCJA increases the user cost of capital for owner-occupied housing from 2018 through 2025 and for research and development beginning in 2022.
8. Based on these figures, TCJA would boost U.S. federal debt held by the public by 3.9% by the end of 2020 and by 6.6% by the end of 2027. See CBO. The Budget and Economic Outlook: 2018 to 2028, April 2018.
9. Without taking into account the feedbacks of higher debt service costs and higher taxable incomes, the cumulative deficit by 2027 would reach $1.5 trillion according to the Joint Committee on Taxation and $2.3 trillion according to the CBO.

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