At its June policy meeting, the Bank of Canada reiterated its intention to maintain an accommodative monetary policy as uncertainty over the pace of the pandemic abates and the economy recovers.
We expect the Bank of Canada will keep its policy rate at the zero bound over the summer, if not into next year.
As it has for the past 16 months, the bank is keeping its policy rate at near-zero to maintain liquidity in the commercial markets while continuing its purchases of long-term securities to pressure interest rates lower and facilitate long-term investment.
In its June policy statement, the bank noted the increased prospects for growth, but also cited the need for a consistent policy in the face of uneven growth among the global economies and the threat of a resurgent virus.
The bank also noted the threat of further shutdowns and an employment rate that remains well below its pre-pandemic level, “with low-wage workers, youth and women continuing to bear the brunt of job losses.”
Because of the slack remaining in the economy, we expect the bank will keep its policy rate at the zero bound over the summer, if not into next year. We also think the bank will wait until the fall before considering altering its asset purchases and will need more time to assess developments in the labor market.
Nevertheless, the bank also noted rising confidence and resilient demand. Vaccinations continue to make it easier for Canadians to live normally again. Though the second-quarter economic data is uneven, the prospect of a safer environment has lifted consumer confidence and retail spending.
Nearly two-thirds of Canadians have received one dose of the vaccine, with roughly 13% now fully vaccinated. The drop in newly reported cases to 760 per day and deaths to 25 per day are attributed to the efficacy of the vaccines.
The progress in the economy comes amid the stability in the financial markets created by the Bank of Canada’s policies. The RSM Canada Financial Conditions Index continues to indicate reduced levels of risk being priced into the commodity, equity, bond and money markets. That reduction in risk sets the stage for long-term investments in the new economy, leading to increased productivity and competitiveness, and higher rates of employment and spending.
The RSM Canada Financial Conditions Index continues to indicate reduced levels of risk.
Because central banks have determined that monetary policy is transmitted to the economy through financial conditions, we created the RSM Canada Financial Conditions Index to measure the degree of risk or accommodation priced into financial assets. A value of zero indicates a normal degree of risk. Values below zero indicate abnormal levels of risk that would tend to limit investment. Values above zero indicate an accommodative environment conducive for investment.
Our composite index has been at least 1.0 standard deviation above neutral over the past 11 weeks and now stands at more than 1.2 standard deviations. This is particularly significant because much of the recent improvement has been outside the commodity markets. (Financial conditions excluding the commodity markets have moved from neutral to 1.0 standard deviation above neutral over that same period.)
That implies that overall financial conditions are conducive for an economic recovery in the months ahead. The economic data appears to be responding to the joint efforts by the monetary authorities, who have kept the financial sector functioning, and by the fiscal authorities, who have maintained household income streams and responded effectively to the health crisis.
In the next sections, we’ll discuss the health of the economy and the role of the commodity markets in that recovery and in future iterations of economic growth.
Closing the output gaps
This has been a stratified pandemic, affecting different communities and age groups in different ways. Aside from personal suffering, the impact of the pandemic has been quite unequal in economic terms, among men and women, and at different levels of education.
Even though the business cycle has turned, the recovery has been uneven. There has been early success in the manufacturing sector and for higher-income cohorts, for example, but not for other sectors.
In a summary of the recovery so far, Statistics Canada notes that the housing market accounted for two-thirds of growth reported in the first quarter. And consumer spending has increased for two consecutive quarters on stronger spending on durables and auto sales.
The external sector is also showing signs of recovery, with increases in shipments of aircraft, other transportation equipment and crude oil.
Yet Statistics Canada also reports that unlike the residential investment, total business outlays on non-residential structures and machinery and equipment remain more than 14% below pre-COVID-19 levels. In our opinion, the lack of investment is most troubling for the long-term development of the economy and for widening the basis for individual accumulation of wealth.
To a lesser degree, imbalances in the consumer sector outside of the housing market merit concern. StatsCan reported that government transfers in the first quarter were more than a third higher than pre-pandemic levels. With increases in household disposable income outpacing increases in consumption, the result has been four consecutive quarters of double-digit savings rates.
So households are holding onto a portion of their income as precautionary savings, waiting for the other shoe to drop. The implication is that there is a lot of cash waiting to be spent on foregone household purchases or invested in the housing market at low rates of interest.
How fast that cash is allowed to bleed out of savings will depend on the vaccination program, on the threat to employment and income streams presented by variants of the virus and changes in demand, and on developments in consumer sentiment.
Consumer confidence
Nanos Research determines the strength of Canadian consumer confidence as a composite of household expectations for the economy and real estate, and the state of household finances and job security.
As our analysis shows, consumer expectations followed the economy sharply down during the pandemic, and then rose as evidence of an eventual economic recovery became apparent, particularly in the sharp rebound in the manufacturing sector.
That consumer sentiment regarding pocketbook issues did not suffer as much as expected during the depths of the pandemic can be attributed to the government’s quick response to maintaining household income.
The increase in consumer expectations coincided with the rebound in manufacturing new orders, which speaks to the outsized importance of the production sector in downstream economic activity and to the impact of the virus on housing preferences. New orders are forward looking, as are consumer expectations.
Monitoring the recovery
Statistics Canada has an easy-to-use update on the recovery, measuring the gaps between where we were before the pandemic and where we are now. Here are some of the highlights; numbers are compared to December 2019:
- Total economic activity in the first quarter was 1.7% below pre-pandemic levels observed in late 2019.
- In the labor market, employment and number of hours worked have recovered 97% of their pre-pandemic levels.
- In the production sector, manufacturing sales are 1.3% higher and railway car loadings are 2.1% higher than December 2019.
- In the service sector, limited-service restaurants have recovered 90% of their sales, while sales at full-service restaurants are only 51% of pre-pandemic levels.
- Returning residents and travelers to Canada are only 5% of the entrants recorded at the end of 2019.
The takeaway is that the manufacturing sector is leading the economy out of recession, while the service sector is waiting for the virus to be contained and for the borders to be reopened.
Canada’s export sector
StatsCan also mentioned the impact of increased exports of transportation equipment and crude oil on the economic recovery. For the moment, crude oil appears to be retaking center stage with regard to economic growth and the Canadian dollar.
If in the modern economy, capital flows rather than trade flows determine a currency’s value, then what accounts for the persistence of the commodity currencies of the dollar bloc? The value of a currency should depend on investment flows and the demand for assets that are more indicative of an economy’s potential than simply resource extraction or production of goods whose demand are at risk of fading.
But then there are the so-called “commodity currencies” of the dollar bloc to consider. These are sophisticated societies that supply not-so-sophisticated products to more industrialized centers.
New Zealand’s exports are more edible than anything else. Australia supplies iron ore to Asia, and Canada is the fourth-largest exporter of oil. Yet when the commodity trade is on, it doesn’t matter which resources are in demand. The market’s first impulse is that the dollar-bloc commodity currencies will all move higher.
Generally speaking, when the global economy is expanding, the foreign exchange market assumes the demand for commodities will increase, pushing dollar-bloc currencies higher versus the currencies of the more industrialized economies. For Canada during the past two decades, that means that the Canadian dollar and the price of crude oil move together.
As of 2020, crude oil comprised 32% of Canada’s top 10 exports. That’s followed by cars and automobile parts with a combined 28% share, and gold with an 11% share. Sawn wood, medications, processed petroleum, petroleum gasses and wheat each have 5% shares, while exports of aircraft and spacecraft hold a 4% share. About three-quarters of all Canadian exports and nearly all crude oil exports go to the United States.
In terms of the overall commodity market (of which oil accounts for 10% of the CRB index) commodity prices have become synonymous with Canada’s real GDP growth since the 2008-09 financial crisis.
This is most likely because of advancements in oil extraction and pipeline expansions to American refineries, and the decade-long U.S. economic recovery and increased demand for Canadian supplies of construction material and automobiles.
So what’s next?
The North American economy is on the verge of a great expansion. If allowed to continue and spread beyond parochial interests, the expansion should maintain increases in the demand for commodities, as the takeoff of the CRB index suggests.
The demand for housing in Canada and the United States is likely to continue because of shifting demographics as baby boomers give way and as millennials become the backbone of consumer demand and the workplace. The memory of the pandemic and the benefits of remote working are unlikely to fade overnight.
In particular, we anticipate a continuation of the fossil fuel economy over the medium term. Despite the best intentions to reduce carbon emissions, it will be years before an all-electric economy is universally available. That itself suggests a floor under the price of oil.
And because the market for oil is global and as the U.K. and Europe and then Asia come fully online, it is possible that oil could reach $100 per barrel. Increased demand among developed economies should support a nominal level that was last reached during the 2011-14 immediate recovery from the Great Recession.
But if commodities and oil in particular are so central to the Canadian dollar and to Canadian economic growth, why then should we ask when the Canadian dollar will no longer be a commodity currency? The answer is in the near-devastating commodity price collapse of 2014-16, when oil prices dropped below $30 per barrel.
The global oil glut and commodity price collapse were the basis for the 2014-16 mini-recession that extended the global bout of societal dissatisfaction already brewing after the Great Recession. That ultimately led to ill-informed policy decisions among Canada’s trading partners that will take years to unwind and will continue to affect the health of the Canadian economy if inappropriately addressed.
In the short run, there is no denying that the Canadian economy will benefit from higher commodity prices. In the long run, though, an economy centered on the intellectual capital of its labor force and its ability to produce diversified items of value will result in stable growth that attracts capital.
The democratic economies are at an inflection point and a changing composition of supply and demand for goods and labor. The Canadian government should use the good fortune of rising commodity prices to move the economy toward the next steps of its evolution.
The pandemic shocked the existing hierarchy and exposed its inherent shortcomings for whole sections of the labor force. You might excuse these shortcomings as inevitable at the tail end of decade-long shifts in terms of gender and class. But simply rebuilding an economy suitable for only the previous generation will last only so long.
Investing in the productivity of all Canadians—through measures like the universal expansion of broadband coverage, child care, housing and nutritional security—and capitalizing on the ability of the younger generations to work remotely will allow for sustained growth and the next advances.
For more information on how the coronavirus pandemic is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.
