The Bank of Canada is approaching Donald Trump cautiously.
Stock markets in the United States have surged about 5% since Trump won the presidential election in early November. That enthusiasm is based almost entirely on the prospect of big tax cuts, which Trump promised and the Republican majority in Congress is eager to deliver. Barack Obama’s replacement, “wants to, and probably will, shift the environment from one that makes profit makers villains with limited power to one that makes them heroes with significant power,” Ray Dalio, chairman and chief investment officer at Bridgewater Associates, the world’s biggest hedge fund, wrote in a December 19 post on LinkedIn. One of the biggest reasons U.S. economic growth has been so weak in recent years is the absence of significant business investment. That could soon change.
The Bank of Canada acknowledges the possibility, but it is unprepared at this stage to assume Trump will inspire animal spirits to the extent imagined by investors such as Dalio. The Bank of Canada’s newest forecast, released January 18, predicts Canada’s gross domestic product will expand 2.1% in 2017, a slight increase from the the central bank’s previous outlook of 2%. The improvement is based on a Trump effect. Canadian policy makers assumed that Republican control of the White House and Congress will result in lower corporate and personal taxes. There will questions about whether the U.S. can afford less revenue, but there is little doubt that lower taxes will have a stimulative effect in the short term. Canadian exporters should benefit. The Bank of Canada’s initial assumption is that the tax cuts being discussed in Washington would increase U.S. GDP by about 0.5% in 2018.
Some might have expected a bigger pop from a “fiscal shock” of that magnitude in Canada’s biggest trading partner. Unfortunately, the calculation might not be so simple. The central bank sees three things that could offset the benefits of faster U.S. growth. The first relates to Canada’s competitiveness. Lower taxes on business profits in the U.S. would rob Canada of an advantage that it has used for years to attract investors. The Bank of Canada reckons more international capital will be drawn to Trump’s America, reducing the level of business investment and exports that Canada might have expected otherwise.
The second offset is higher interest rates. Bank of Canada Governor Stephen Poloz stressed at his January 18 press conference that Canada’s economy is much weaker than that of the U.S. He did so because he wants to dissuade bond and currency traders of the notion that Canada is a mirror of what is happening the American economy. American interest rates are rising, a reasonable response to the prospect of stronger economic growth and faster inflation. Canadian yields have been rising too, for no apparent reason other than the assumption that the historic correlation between the Canadian and U.S. economies still holds. It doesn’t, said Poloz. Canada still is coping with “material excess capacity” because of the collapse of oil prices. That is putting downward pressure on inflation and likely will keep the Bank of Canada from raising its policy rate until some time in 2018. (In fact, Poloz said on January 18 that an interest-rate cut “remains on the table.”) Yet market rates are rising anyway. Higher borrowing costs will curb demand and reduce growth.
And finally, there is the dollar. The perception is that Canada’s currency is weak, but that is not entirely true. The loonie has lost ground to the U.S. dollar in recent years, and was worth about 76 U.S. cents on January 18. Against other currencies, such as the Mexican peso, the loonie has done just fine. That’s because oil prices have stabilized, and also because traders appear to assume a stronger U.S. dollar means the Canadian currency should be stronger too. This creates two headwinds: the stronger U.S. dollar will hurt U.S. exports, and therefore crimp demand for Canadian components; and Canadian suppliers will struggle to compete with rivals in Mexico and other countries that enjoy a better exchange-rate advantage.
“The uncertainty we face as forecasters and policy maker remains undiminished,” Poloz said. The era of the “profit maker” may well be nigh. It is too soon to know how much of the wealth will spill over the Canada-U.S. border.
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