Finance Canada
Budget 2000 - Budget Plan, Chapter 2: Economic Development and Prospects - 2
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The Economic Outlook and Risks

External Environment

Overall economic conditions in both the overseas economies and the U.S. are anticipated to remain conducive to growth and job creation in Canada in the coming years. The OECD forecasts that world growth will increase from 3 per cent in 1999 to average about 3.5 per cent in 2000 and 2001 (Table 2.1). This is forecast to result in some upward movement in world interest rates. As expected, major central banks started to raise interest rates earlier this year.

Table 2.1
Global Outlook for Real GDP Growth

Overseas Economies

All of the major European economies are expected to post solid growth during the next two years, following a temporary slowdown in 1999. With real growth in these countries forecast to strengthen significantly in 2000, prospects are for European interest rates to rise somewhat over the next two years.

Economic conditions in Japan are projected to remain steady over the next two years, with forecast real GDP growth virtually unchanged from its modest pace in 1999. Renewed weakness in the Japanese economy in late 1999 highlights the risks to a domestically led recovery in Japan, particularly given the transition costs related to ongoing structural reforms.

United States

The U.S. economy continued to post strong growth in 1999, with little sign of any increase in underlying inflation. Real U.S. GDP growth is estimated to have averaged 4 per cent in 1999, maintaining the same robust pace for a third successive year (Table 2.2). The Blue Chip survey of U.S. forecasters calls for a gradual slowing in real growth in the near term, reflecting a slowdown in spending on interest-sensitive components of demand, such as housing and consumer durables, due to higher interest rates. Real GDP growth is now forecast to fall to 3.6 per cent in 2000 and to 3.0 per cent in 2001, a more modest slowdown than expected last autumn.

Table 2.2
U.S. Outlook: Blue Chip Forecast

This "soft landing" outlook is consistent with the view that moderate increases in interest rates will be required following those over the last year to slow domestic demand to a more sustainable pace.

Canada’s Economic Prospects

The favourable global economic prospects and healthy domestic conditions brighten Canada’s near-term economic outlook. Building on the momentum established in 1999, the Canadian economy is expected to be led by domestic demand over the near term. Continued low and stable inflation and sound public finances, as reflected in falling government debt and tax burdens, are working together to reinforce this positive outlook.

Moreover, the benefits for Canada of a stronger world economy and the resulting support for commodity prices – combined with firm domestic demand – should also help offset much of the negative impact of the expected slowing in the U.S. economy. As a result, Canada is poised to enjoy continued healthy growth over the near term in spite of the upward drift in interest rates around the world.

Average Private Sector Forecast

Consistent with improving domestic and global economic conditions, private sector forecasters have made significant upward revisions throughout the past year to their expectations of economic growth, inflation and interest rates. Real GDP growth is now estimated to have increased significantly from 3.1 per cent in 1998 to 3.8 per cent in 1999 (Table 2.3).

The December 1999 survey of private sector forecasters shows average forecast real GDP growth slowing only modestly to 3.5 per cent in 2000 and 2.9 per cent in 2001. This view likely reflects the expected cooling in U.S. economic growth over the same period, as well as the effects of somewhat tighter Canadian monetary conditions. The realization of such strong growth will mark the longest sustained economic expansion in two decades.

GDP inflation is now estimated to have averaged 1.6 per cent in 1999, up significantly from the decline in GDP prices of 0.6 per cent in 1998. Stronger GDP prices over the last year are due in part to the recovery in commodity prices. Private sector forecasters anticipate GDP inflation to edge up further to around 2 per cent during the next two years.

Overall, nominal GDP (which includes the impact of producer price inflation) is estimated to have grown 5.4 per cent in 1999. Private sector forecasters expect nominal GDP growth to average 5.7 per cent in 2000 and 4.9 per cent in 2001. This means that the total value of goods and services produced in Canada will exceed $1 trillion next year. The forecast level of nominal GDP for 2000 is now over $40 billion higher than predicted at the time of the 1999 budget and $13 billion higher than predicted in the 1999 fall update survey.

Table 2.3
Evolution of the Average Private Sector Forecast for Key Indicators

Private sector forecasters have also become more positive over the last year about job creation. Employment growth is expected to slow less than previously forecast this year, from 2.7 per cent in 1999 to 2.2 per cent in 2000 and 1.7 per cent in 2001, in tandem with the forecast easing in real GDP growth. Healthy labour market conditions are expected to induce a moderate improvement in labour force participation (the share of work-eligible Canadians holding or seeking jobs) over the same period. As a result, the unemployment rate is forecast to continue to average slightly below 7 per cent during the next two years, following significant declines in 1999.

Higher economic growth forecasts in both Canada and the U.S. have been accompanied by upward revisions to private sector interest rate forecasts. Canadian short-term interest rates are now expected to average 5.2 per cent in 2000 and 5.3 per cent in 2001, about 10 to 20 basis points higher than forecast in the 1999 fall update survey. These upward revisions are consistent with increases in interest rates that have occurred since then, as well as upward revisions to U.S. interest rate forecasts for 2000.

Long-term interest rates are expected to average 6.2 per cent in 2000 and to decline modestly to 6.0 per cent in 2001. This indicates that inflation pressures are widely expected to remain contained over the next two years, and reflects continued progress in reducing government debt-to-GDP ratios as well as the success of the inflation control targets.

Private sector forecasters project consumer price inflation to ease from current levels in 2000, moving closer to the midpoint of the target band (1 to 3 per cent) set jointly by the Government and the Bank of Canada. This is consistent with expectations that the temporary pass-through effect of the significant increase in energy prices last year will ease over the near term.

The OECD and IMF share this positive assessment of Canada’s growth prospects. Indeed, Canada is expected to post the second fastest economic growth among the Group of Seven major industrial countries in 2000 and to lead in job creation. The OECD and IMF also forecast inflation to remain well within the inflation target band.

It should be noted that economic and financial market developments since the last complete survey of private sector forecasters in mid-December have led to some revisions to private sector views. Although a full round of updated forecasts will not be available until March, a number of private sector forecasters have revised upwards their expectations for interest rates and growth in both Canada and the U.S. In particular, results from a partial survey of private sector forecasters conducted in early February indicated expectations that Canadian short- and long-term interest rates would average around 25 basis points higher in 2000 and 2001 than in the December survey. Preliminary expectations for real GDP growth were also slightly higher (0.2 percentage points in 2000 and 0.1 percentage points in 2001).

From a fiscal perspective, such revisions would be roughly neutral as the positive implications of higher growth forecasts offset the negative effects of higher interest rate forecasts. Hence, the fiscal projections prepared on the basis of the December economic forecasts remain an appropriate basis for budget planning.

Risks to the Canadian Outlook and Economic Prudence

The main risks to the economic outlook stem from possible developments abroad, mainly in Canada’s largest trading partner. The U.S. economy posted higher-than-expected income and productivity growth but lower-than-expected inflation in 1999. Temporarily depressed import and energy prices following the Asian crisis contributed to this impressive performance. However, a significant increase in productivity growth – rooted in technological advances in the production of computers and increased use of computers across industries – has also played a major role by expanding the non-inflationary growth capacity of the U.S. economy.

Despite this increased growth capacity, it is widely believed that domestic demand growth in the U.S. must moderate somewhat from current rates if inflation pressures are to be avoided. Forecasters are still generally of the view that further moderate increases in U.S. interest rates will be sufficient to achieve the needed moderate slowing in growth. However, the emergence of inflationary pressures is considered to be the most significant risk to the U.S. economic outlook. Concerns have also been raised regarding other potential imbalances in the U.S. economy, such as the high current account deficit, which may complicate the conduct of monetary policy. These concerns suggest that more significant increases in U.S. interest rates than are currently anticipated may eventually be necessary to slow U.S. growth sufficiently to avoid inflation pressures. As witnessed by developments since the beginning of the year, higher-than-expected increases in U.S. rates could spill over to Canada in the form of higher Canadian interest rates.

Evidence that the non-inflationary capacity of the Canadian economy has also expanded in recent years counterbalances these risks to the outlook. While there is much uncertainty surrounding any estimate of the non-inflationary productive capacity of the Canadian economy, there are signs that Canada’s capacity to sustain robust, non-inflationary growth has increased as a result of structural reforms, the restoration of sound public finances and technological developments. For example, increases in unit labour costs remained well below inflation in 1999 – and indeed decelerated over the first three quarters of the year – despite robust growth and substantial declines in the unemployment rate.

The risks to the economic outlook underscore the importance of maintaining the prudent planning approach of past budgets. This is why fiscal planning in every budget starts by establishing the amount of economic prudence required to cushion against potential pressures on government finances due to higher-than-expected interest rates or lower-than-forecast growth. This helps to ensure that the Government can continue to meet its commitment to balanced budgets or better. Since risks to the outlook appear to remain balanced, economic prudence has been set at normal levels of $1 billion in 2000-01 and $2 billion in 2001-02, as in the 1999 Economic and Fiscal Update.

¹ Includes data up to February 11, 2000. National economic and financial accounts data for the fourth quarter of 1999, released on February 28, 2000, are not included.

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