Blockbuster Run of Data Casts Doubt on Poloz's Divergence NarrativeBy
Central bank chief says Canada has much more slack than U.S.
Recent robust data suggest countries are on more even footing
The Canadian economy has “a lot more room to grow” than its American counterpart, the head of the country’s central bank Stephen Poloz said last week, pushing back against the idea he would soon follow his peers stateside in lifting interest rates.
Such an assessment of the relative amount of slack between the two nations would have been uncontroversial in 2015, when back-to-back quarters of economic contraction amid the collapse in commodity prices elicited a pair of rate cuts from the Bank of Canada.
But the Canadian economy’s recent run of form casts doubt on the idea it’s still much further than the U.S.’s from home. Growth hit a torrid pace of 0.6 percent month-on-month in January -- putting the exclamation mark on a blockbuster string of data that has propelled the nation’s economic surprise index to its highest level since 2010, and showing that lingering excess capacity has been absorbed rapidly.
“Canada has a lot more room to grow, because we have not recovered fully from the oil price shock,” Poloz told reporters Tuesday after a speech in Oshawa, Ontario, adding “we have a level difference between the two economies, more unemployment, more excess capacity, a cushion there, which means that we can grow faster than the U.S. for a while to use up that capacity.”
It was the latest of several recent communiques from the Bank of Canada that emphasized the nation’s economic divergence from the U.S. -- but this is not the kind of divergence the central bank may have had in mind.
“It’s still true, but not as true as it was six months ago,” CIBC World Markets chief economist Avery Shenfeld said by phone Friday. “The gap is closing quickly.”
A Different Divergence
The second half of 2016 saw the Canadian economy expand at an above-trend pace, and monthly job growth has exceeded economists’ expectations for seven consecutive readings. Stateside, however, it looks to be another sluggish start to the year for the U.S. economy, with the Atlanta Fed’s GDPNow tracker pointing to sub-1 percent growth in the first quarter.
With these kinds of numbers, “that relative difference is going to shrink very quickly,” Brian DePratto, senior economist at Toronto-Dominion Bank, said by phone Friday. “It’s difficult to make the case that we have significantly more slack.”
The Output Gap
At issue is the output gap: the cumulative difference between how fast economic models suggest a nation can grow, and its actual rate of expansion. Central bankers set interest rates with the aim of meeting their inflation mandate and smoothing the business cycle by targeting a zero output gap, which is consistent with an economy operating at its fastest sustainable pace.
Some economists say the divergence is moving in Canada’s favor, at least in much of the country.
“By the end of the third quarter of 2016, the output gaps in Canada and the U.S. looked very similar,” Randall Bartlett, chief economist at the Institute of Fiscal Studies and Democracy, said by phone Sunday. “Since then, Canada’s growth has been above potential and in the U.S. that’s not the case, so our output gap is either in line or maybe smaller at this point.”
Most provinces -- including Ontario, Quebec, and British Columbia -- are probably operating at an unsustainably high pace, Bartlett reckons, while persistent excess capacity remains in resource-producing provinces like Alberta, Saskatchewan, and Newfoundland and Labrador.
Since potential growth can only be estimated, the output gap is an unobservable metric that’s subject to considerable uncertainty. But it’s an integral theoretical construct for formulating monetary policy.
To be sure, a number of observable data support Poloz’s view.
Despite robust headline job growth as of late, the labor market is the chief place where Canada appears to lag far behind the U.S., said CIBC’s Shenfeld, citing the loss of high-productivity jobs in the resource sector that he expects will gradually return in Canada and the difference in pay gains between workers in the two countries.
“Wages are starting to heat up in the U.S., but if you take all the various measures of wages in Canada you conclude they might be running at around 2 percent,” he said.
Nor do measures of core inflation point to an economy that’s on the verge of overheating, said TD’s DePratto, and a pick-up in capital spending has remained elusive.
“On the business investment side of things, there’s been more progress in the U.S. relative to here,” he said. “That’s been an area of concern for some time, and there’s not a whole lot in the data that makes you think investment in particular is going to come back.”
A report Monday by the Bank of Canada though suggests that even here there is room for optimism, with investment intentions at the highest since 2010.
For market-watchers, however, assessing the accuracy of Poloz’s statement takes a back seat to discerning the signal he’s trying to send through such a remark.
The governor is “trying to be a two-handed economist,” said Shenfeld. On the one hand, “admit that the outlook is brightening, but keep the focus on downside risks given uncertainties surrounding U.S. tax and trade policy.”