A sobering look at the Canadian economy by the Finance department argues that the recent rapid pace of growth is not sustainable over the next five years. As reported in the Canadian press today, an internal memo for Finance Minister Bill Morneau indicates that potential growth will be contained at 1.7 % through to 2022. The department’s review is taken in consultation with private economists and so represents a fairly widely held consensus within the profession. This is a far cry from 3% growth recorded in 2017. It is time for a reality check on what lies behind this downshift.

The Bank of Canada regularly recalibrates Canada’s output potential. Potential output growth is the sum labor productivity and labor force expansion. Recently, the Bank’s staff  [1] looked at each trend, noting that:

• The slowdown in labor productivity (LP) reflects the widespread weakness in business investment following the oil price collapse of 2014-15; the Finance department’s  memo emphasizes that “there is no silver bullet to raising Canada’s productivity growth”; sluggish productivity growth is a chronic issue facing all advanced economies.
• The labor force (LF)  is expected to decline steadily from 0.7 % to 0.5% in a space of just three years, as the population ages, offset slightly by higher immigration levels.

Potential output measures should not be taken to be scientifically precise. While the trend in labor force growth is baked in by established demographic forces, productivity measures are less firmly well established. Many factors influence productivity results such trade policies, education, development of new products and technological developments.

What are the main takeaways from this analysis? First, a slow down will not likely ignite inflation and we can anticipate a continued low inflation environment throughout the period. A slow growth environment places a lot of restrictions on how far the government can expand fiscal policy. Second, although the conventional wisdom calls for a steady increase in short-term interest rates, sluggish growth and low inflation will put a lid on just how far rates can move up before economic growth is halted.

[1]  Bank of Canada ,Annual Reassessment of Potential Output Growth in Canada, Staff Analytical Note 2017-5