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Monthly Economic Letter

September 2019
Feature article

Will the Bank of Canada cut interest rates this year?

While the U.S. and other countries have cut interest rates this year, it seems unlikely the Bank of Canada will follow suit.

In the U.S., the Federal Reserve cut its rate in July, portraying the move as a preventative measure in response to weak global growth and trade uncertainty. However, the U.S. economy has already slowed as the stimulative effects of last year’s tax cuts wear off and the trade war with China begins to take a toll. (See the U.S. economy at a glance for more details.)

And the damage from trade tensions hasn’t been restricted to the U.S. and China. It’s weakening business confidence and slowing trade and investment around the world.

That’s why the U.S. bond market is betting more cuts are coming from the Fed this fall while elsewhere other central banks are also cutting rates.

Will the Bank of Canada join the party? It seems unlikely.

The bank must strike a balance between managing downside risks and dampening inflationary pressures and asset bubbles. For now, the bank’s current rate appears to be still stimulating the economy because in real terms it’s negative (more on this later).

A lower rate could incite more borrowing by already heavily indebted households. Indeed, Canadian household debt is at a historic high of 100% of GDP. Since 2017 the bank’s 1.25% increase in interest rates have pushed households’ debt service ratio—the share of a disposable income allocated to pay debt obligations—to the same high level as in the fourth quarter of 2007. As more disposable income is spent to pay debt, consumption has slowed—to just 0.5% in the last quarter compared to a pace of 3.6% in 2017. Lower household spending is slowing overall economic growth.

Despite the headwinds from trade tensions, the bank’s concern about household debt is likely to keep interest rates where they stand.

Diverging monetary policy

Traditionally, when the U.S. cut interest rates, Canada matched the moves of our largest trading partner. Lately, things have been different.

While both countries dropped their policy rates to 0.25% during the Great Recession, Canada moved back to 1% by 2014. That gave the Bank of Canada the flexibility it needed to support the economy by dropping rates when global oil prices plummeted from over US$100 a barrel.

Meanwhile, the U.S. kept its policy rate at 0.25% for much longer—until December 2015—to support growth. Finally, in 2018, the Fed steadily hiked its rate to 2.5%.

When we consider the real interest rate—that is the nominal rate less inflation—we see that interest rates in the U.S. remained much more accommodative than in Canada until March 2017.

U.S. enjoyed stronger economic growth

The lower interest rates allowed for stronger economic growth in the U.S.—until late 2016 when Canada’s growth rate picked up strongly, driven in part by lower real interest rates.

Now, some are suggesting the Fed went too far in raising rates last year, and they may have a point. If the real neutral interest rate—one that is neither stimulating nor restricting the economy—is about 0%, then the U.S. has had a restrictive policy rate for the past year.

While the Fed said its July rate cut was meant to insure against downside risks, the economy has already slowed and business investment contracted for the first time since 2016.

With central banks in the U.S. and Canada confronted by different economic realities, this looks like another year when the two countries go their own ways on interest rate policy.

What does it mean for entrepreneurs?

  1. Interest rates are unlikely to rise any time soon given that the U.S. recently lowered its policy rate. With borrowing costs remaining low, consider where you can invest to improve your profitability and grow.
  2. The Canadian dollar may appreciate against the greenback given the bond market’s anticipation of further rate cuts in the U.S. If you are importing goods from the U.S. this autumn may be a good time to make your purchases.
Canadian economy at a glance

Exports drive Canada’s growth as domestic spending slips

Despite trade tensions and a slowing global economy, Canada posted impressive 3.7% annualized growth in the second quarter, the strongest pace since 2017.

However, the growth was not balanced. Exports propelled the economy in the quarter, but household spending slowed, and business investment contracted.

Goods exports performed strongly, growing a remarkable 15% in the quarter. There was strong demand for Canada’s agricultural products, industrial chemical products, transportation equipment and energy. And following the elimination of U.S. tariffs on May 20, steel and aluminum exports rebounded sharply.

Travel services also grew by a solid 10% in the quarter. A favourable exchange rate for Americans and Europeans no doubt persuaded them to visit Canada, especially during the exciting NBA basketball championships in Toronto.

Consumer spending slumped

On the downside, consumers continued to feel the pinch of higher interest rates, with household spending slowing to a pace of 0.5% annualized—the slowest since 2012. Household purchases of services continued to grow but buying of durables such as furniture and major appliances slowed.

Perhaps showing signs of caution about the future, households increased their savings, which hit 4.1% of disposable income, up from 2.8% in the first quarter.

The outlook for spending to rebound does not look promising given that consumer confidence has been declining since early July according to the survey by Nanos/Bloomberg. And while the economy continues to add jobs—over 80,000 in August—the majority were in part-time employment.

Business investment contracts

Business spending contracted last quarter, reversing the prior quarter’s gains. Declines in machinery and equipment purchases drove the overall drop, though a bright spot was a rise in computer purchases. Tax changes implemented last year allowing businesses to immediately expense many capital goods, including computer and software purchases at 100%, should help more businesses make the investments they need to increase productivity.

The low level of business confidence likely explains the slower pace of investment. Confidence is a key driver for investment.

Furthermore, capacity utilization, which has fallen over the past six months, suggests that businesses are unlikely to invest significantly in the coming period.

Residential investment finally turns around

After five quarters of contraction, the housing sector finally grew last quarter. Resale activity increased as did investment in new homes, especially multi-dwelling units, as well as renovations of existing buildings.

Interest rates expected to stay low

With core inflation on target, and global headwinds mounting, the Bank of Canada is unlikely to raise interest rates any time soon. See more details in the main article.

What does it mean for entrepreneurs?

  1. Consumers are likely to continue to slow purchases of big-ticket items, so retailers may need to enhance the value of their product offering to make these sales.
  2. Consider whether the accelerated capital cost allowance can help you buy machinery and equipment to improve your business’s efficiency.
  3. Interest rates remain relatively low meaning the cost of borrowing to invest is still affordable.
U.S. economy at a glance

Trade war starts to bite

Economic growth in the United States slowed to 2% in the second quarter amid signs that businesses are feeling the effects of the trade war with China.

Tariffs imposed by the two countries are slowing trade and the uncertainty about future trade policy is forcing businesses to delay investment.

The American consumer was responsible for what growth there was in the quarter, with household spending contributing a healthy 3.1% to GDP growth.

Trade tensions are affecting businesses

American business confidence has steadily declined as more tariffs have been implemented. Business confidence is critical for making investment plans, and the weakening can be seen in a drop in second-quarter business investment, which contracted for the first time since 2016.

Some analysts are concerned the contraction in business investment could signal a coming recession.

Already, the manufacturing sector has been directly affected by the trade war, with output declining in the first quarter. Furthermore, the IHSMarkit survey of manufacturing purchasing managers slowed again in August after a soft July—posting the weakest growth since 2009.

Consumers remain resilient

So far, the U.S. consumer is holding up the economy. Accounting for roughly 70% of U.S. GDP, consumer spending is an important barometer for the health of the economy. It increased at a very strong pace of 4.7% in the second quarter driven by a 12% rise in durable goods purchases.

A solid labour market is supporting consumer spending. The economy added 130,000 jobs in August—more than enough to absorb new entrants to the labour market. Furthermore, average hourly earnings are gradually picking up, rising 3.2%, compared to a year ago.

Last year, import tariffs had a limited impact on households. Many companies built up inventory prior to certain tariffs coming into effect and some firms absorbed the duty costs into their profit margins. Furthermore, inflation has remained low at 1.7% in July.

While the first two rounds targeted primary and intermediate goods, the latest round targets consumer goods. President Trump knows consumers will be more sensitive to higher prices on these items. That’s why he delayed the tariff implementation date to mid-December on more than half of the targeted goods.

Based on the tariffs in place last year, the Federal Reserve Bank of New York estimated that the average households’ duty costs were US$282 a year. In May, tariffs went from 10% to 25% on US$200 billion worth of Chinese goods and President Trump has threatened that all existing items ($250 billion) will rise to 30% on October 15. The remaining trade with China will be targeted with 15% tariffs in two steps: This month and in December. JP Morgan Chase estimates the average household's duty costs will rise to over US$1000 a year.

The next few months will show how well the U.S. economy can withstand the trade war.

Interest rate cut to support the expansion

As economic activity has slowed and risks are firmly pointed to the downside, the U.S. Federal Reserve cut its policy interest rate in July. Economists are expecting at least two more cuts by the end of the year. It is debatable whether interest rate cuts will be enough to stimulate further investment. Confidence and expectations for future growth are key drivers of investment.

What does it mean for entrepreneurs?

  1. Interest rates could fall further as trade tensions continue to mount.
  2. If you export to the U.S. continue to demarcate your business as a valuable supplier.
  3. The lack of a U.S.-China deal likely to continue to weigh on confidence globally.
Oil market update

Trade uncertainty hits oil prices

Global oil prices trended lower over the past weeks as trade tensions between the United States and China mount.

Markets have become increasingly worried that the escalation in trade tensions is slowing global growth. Indeed, the International Monetary Fund revised its estimate for global growth to 3.2% for this year—the slowest pace since 2009.

Slower economic growth means less demand for oil products.

Oil demand weakness is widespread

Global demand for oil has declined to its lowest level since 2008, with the International Energy Agency anticipating growth of just 1.1 million barrels a day (mb/d) for 2019 and 1.3 mb/d in 2020.

Global trade is a key indicator for the evolution of the demand for oil given its importance in transporting goods. World trade began to slow last autumn and has contracted by 3.2% between October and June, according to the Netherlands Bureau for Economic Policy Analysis.

Car sales are another useful barometer. Both the petrochemical sector, which produces plastics and other products used in car manufacturing, and gasoline markets are affected by weaker car sales. In the first half of this year, car sales declined in China, Europe and the United States. In the U.S., gasoline demand was lower in July compared to a year ago.

Despite OPEC+ cuts, oil market still well supplied by US production

Saudi Arabia, Russia and other countries party to the OPEC+ agreement continue to reduce supply—by roughly 2 million barrels a day in July compared to a year ago. Some of the drop is involuntary as U.S sanctions on Iran and Venezuela are restricting oil supply to the global market. The OPEC+ group has committed to maintaining cuts until March 2020.

However, despite this effort, prices are likely to continue to dip lower. This is due in part to the U.S. pumping oil at exceptionally high levels. U.S. crude oil production remained above 12 million barrels a day in August. This stretches a streak that started in February 2019. Production has topped this level every week with the exception of one week in July when Tropical Storm Barry shut in production in the U.S. Gulf Coast.

As demand weakens and U.S. supply rises, global prices are likely to continue to slide. Some analysts believe that OPEC+ must cut another one million barrels of oil, otherwise Brent will likely fall below US$60 a barrel.

Canada’s main oil price remains steady

Prices for Canada’s main oil export, Western Canadian Select (WCS), have fluctuated in line with West Texas Intermediate. The differential between the two has remained stable at around US$12-13 a barrel recently despite increasing production. The production curtailment will stay in place until the end of 2020, giving support to the price of WCS. This is good news for the Canadian oil industry. Furthermore, construction will start on the Trans Mountain pipeline this month, and if all goes well, it should be in service by the middle of 2022.

Bottom line

Global prices are likely to fall further as global growth concerns mount. Despite production cuts by OPEC+, supply from other countries, especially the U.S., will likely put more downward pressure on prices.

Other economic indicators

The key rate remains unchanged

On September 4th, the Bank of Canada maintained its policy rate at 1.75%. The Bank is faced with conflicting signals. Second quarter GDP was quite strong at 3.7%, however, the trade war between China and the United States poses a threat to the global economy. See the main article for more details.

The loonie is slightly down

Over the past two months, the Canadian dollar depreciated by nearly 2% against the US dollar. Slower global economic growth could threaten Canadian exports and put further pressure on the loonie.

Confidence rises again

SME owners' confidence improved slightly in August, erasing most of the losses recorded in July. The CFIB Business Barometer Index rose nearly three points to 60.6. It is only the second time since the beginning of the year that it has exceeded the 60-point mark (an index level of between 65 and 70 means the economy is growing at its potential). The increase is broad-based, affecting 8 out of 10 provinces. The most optimistic province is Quebec (67.7), followed by Nova Scotia (67.2) and Prince Edward Island (66.7). Sectors with the highest confidence are: Information, arts and entertainment (66), accommodation and food (65.6) and finance, insurance and real estate (64.4).

Effective rates continue to drop

Between January and end of August, the effective business interest rate has fallen 40 basis points and now resides at 3.4%. The effective household interest rate fell from a 10-year high of 4% in early March to 3.7% in August. Effective rates have declined largely in line with government bond yields.

Key indicators—Canada