We are considerably more bearish than the consensus on Canada's medium-term economic outlook. Our concerns in Canada are not as fundamentally deep as in the US; Canada faces neither the deflation of a housing bubble nor the myriad risks relating to the accompanying overhang of debt.
But Canada does still sell 25% of its national output to the US, and particularly with the Canadian dollar's high level adding competitiveness concerns, we think that the unfolding US
recession can hardly help but result in profound cyclical slowdown in Canada.
An important part of that view is the forecast that prior cyclical supports to Canadian growth will be fading over the medium term.
More concretely, we have been assuming that commodity prices will generally be leveling off in the quarters ahead. That aspect of the view has been challenged in recent weeks.
The BoC's commodity price index, which is weighted in line with Canadian production, hit a new all-time high of 253.3 last week. The index is up 7.8% over the past two weeks (the largest such rise since late 2005), now standing 13.2% above the Q4 average and 25.7% above its level a year ago (see Chart 1).
Oil, gas, metals and grain prices have all contributed importantly to the rise. Commodity prices dominate movements in Canada's terms of trade (see Chart 2).
A useful rule of thumb is that a 4% rise in prices tends to translate into a 1% rise in the terms of trade. Higher terms of trade are a positive income shock to the economy (Canada earns more for its exports in terms of what they buy from other countries), fueling the favourable constellation of stronger domestic demand, profits, government revenues and markets that we've observed in recent years.
The BoC's new large-scale macro model was specifically designed to better capture the commodity price effects on the economy (called ToTEM, for 'Terms of Trade Economic Model').
In introducing the model in late 2006, BoC researchers wrote that "Perhaps the most striking feature of the results is just how important
commodity prices are for the Canadian economy and how long lasting the effects of even a temporary change in commodity prices (roughly three years) can be."
The recent rise in commodity prices is even more bullish for Canadian prospects because, unusually, it has not driven a rise in the Canadian dollar, which has traded in a tight range either side of USD parity since the beginning of the year. A rise in commodity prices not matched by a stronger CAD implies an 'effectively' weaker exchange rate; in years past the BoC would have called it a 'Type II' move- an effective loosening of monetary conditions that should influence policy.
Our key uncertainty here is how durable the recent run-up in commodity prices will be. We know those prices can be volatile with highly inelastic supply and demand curves, we've seen these boomlets reverse before, and we have a hard time seeing prices continue to rise sharply in an environment of slowing US and global
demand.
Nonetheless, if our broadly flat medium-term commodity price forecast proves incorrect, a lot of our other Canadian forecasts, including on the economy and the equity market, will also prove to have been too pessimistic.
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