Economic Outlook : 
Playing the Long Game

For the last three years, governments, businesses and workers have confronted a series of shocks and disruptions that have tested their agility and resilience. The pandemic, the war in Ukraine, supply chain constraints, swings in commodity prices, and higher inflation and interest rates, have demanded swift responses and adjustment. There are aftershocks, uncertainty and risk, and still a need to adapt. Navigating turbulent times remains a key function of policy and business planning.

Yet, given forces shaping the world of tomorrow, it matters even more how governments and businesses plan to invest, innovate and create the conditions for sustainable growth over the longer term.

This Economic Outlook entitled Playing the Long Game reviews recent developments and short-term prospects, sets out a baseline scenario and risks to assist business planning and describes some of the context for the longer term and key tasks ahead for Canadian governments and firms.

In the short term, the priority is to re-balance demand and supply and to get back on a path of non-inflationary growth. Longer term, in a fragmented world, Canada has to up its game, raise the proportion of national income that it devotes to investment relative to consumption and equip its workers with more and better skills and capital to succeed in domestic and global markets.

A Slowing of the Global Economy

Price inflation has come down from the peaks of mid-2022, but it remains high. Hikes in the policy interest rates of central banks have helped to moderate demand and rates need to be high for longer. Inflation will not get back to target quickly.

Consequently, global growth will be weak in 2023, recover some momentum later in 2024 and only by 2025 be at roughly potential for the medium term, with low inflation. We use as backdrop the latest World Economic Outlook of the International Monetary Fund (IMF) to the end of 2024. The IMF projects global real gross domestic product (GDP) growth of 2.8% in 2023 (down from 3.4% in 2022) and 3% in 2024.

The only major economy diverging from others is China. It is rebounding in 2023 after abandoning its zero-COVID policy: the IMF projects growth of 5.2% in 2023 (up from 3% in 2022) and 4.5% in 2024. Recent developments draw into question the strength of the recovery in China, but authorities no doubt will aim to achieve their growth target for 2023 of 5%. India is notable because of the pace of its projected expansion: 5.9% in 2023 and 6.5% in 2024. China and India together are likely to account for roughly one half of global growth in 2023; Asia, as much as 70%.

There are risks of recession and disorderly adjustment. Inflation may be “sticky” and this could stretch out the path of return to noninflationary growth to beyond 2025. While U.S. and European authorities acted quickly in March 2023 to resolve failing banks, there is financial stress given record levels of public and private debt. Intensification of the war in Ukraine, or rising tension over Taiwan, could push up commodity prices, depress confidence and unsettle capital markets.

A More Complex and Fragmented Global Environment

There will be lasting impacts of the recent shocks, at the same time as a need to adjust to structural change driven by demography, climate change and technology. After decades of falling real interest rates because of chronic global excess savings, there is reason to expect that even when inflation is back at target, nominal and real interest rates will be higher than pre- COVID. Growth potential will be lower. The IMF has the lowest global growth projection for the next five years since 1990.

Globalization as pursued over the last decades has peaked, and markets are becoming more fragmented. In a period of intense geopolitical rivalry, trade and investment are influenced by the joint pursuits of national security and economic security. The United States and the G7 insist they are not “de-coupling” from China, rather “de-risking” activity and supply chains, but the consequences in industries from critical minerals to semi-conductors are profound. The World Trade Organization is becoming less effectual as trade rules are determined by an expanding universe of bilateral and plurilateral deals, and by the unilateral measures of large economies. Meanwhile, the search for competitive advantage in such strategic industries as clean tech or electric vehicles is giving free rein to industrial policies and subsidy wars that can also have protectionist motives or effects. The digital space, its standards and rules, is also a battleground for strategic and economic advantage.

There are opportunities still to grow markets. For Canadian businesses, there is advantage procured by under-utilized trade agreements with the United States and Mexico, the European Union and with some of the strongest and most dynamic Asian economies. For businesses, de-risking means building markets and supply chains that are resilient in a fragmented world, while responding to rising environmental, social and governance (ESG) obligations and market expectations.

The U.S. and Canadian Economies to the End of 2025—Cooling Down and Converging to Potential

Given global circumstances, as well as domestic uncertainty and risk, there is a range of plausible outcomes for the U.S. and Canadian economies over the next 24 to 30 months.

The starting point is output above potential, stubbornly high core inflation and tight labour markets. Despite the sharp interest rate hikes initiated by both central banks in March 2022, demand has proven resilient.

We judge that policy interest rates (at 5.25%, upper limit, for the Fed funds rate and 4.75% for the Bank of Canada rate, as of June 7, 2023) are at, or near, their peaks. We do not expect any loosening of monetary policy in 2023. Policy rates would come down only gradually in 2024 and 2025.

The high interest rates will cool down the two economies in the quarters ahead. We project that over the period of the second quarter of 2023 to Q2 2024, real GDP will grow at annualized rates of 0.8% in the United States and 1% in Canada. With inflation on a downward track, and with cuts in interest rates, growth would then firm up, to an annualized average of 1.9% in the United States and 2.5% in Canada to the end of 2025. Stronger immigration flows in Canada contribute to more rapid growth than in the United States by boosting both potential output and aggregate demand.

Getting inflation back to target—for Canada to the middle of the 1% to 3% band—will not bean easy task. Services price inflation is persistent and it could be accentuated by wage pressure. Even in our baseline scenario, headline inflation will be slightly above 2% in Canada by the end of 2025.

By this time, we expect policy interest rates to be about neutral, neither stimulative nor restrictive: in a range of 3% to 3.25% in the United States; and 2.75% to 3% in Canada. Ten-year government bond rates would be about 3.25% to 3.50% in the United States and 3.0% to 3.25% in Canada. These interest rates would be representative of averages to expect over the business cycle in a post-COVID world.

There are risks to this scenario. If global developments cause new stress, or if inflation is stickier than expected, there could be a recession, but more likely a prolonged period of low growth and adjustment. The recent agreement on the debt ceiling in the United States clears some of the skies.

The Longer-Term Lens: Skills …

While the parameters that determine short-term developments can be volatile, factors such as population aging, climate change and technology, and in particular digitalization, are exerting more predictable and durable forces on the economy. Governments and firms have to plan accordingly.

With the help of simulations to 2032, we dispel one recurrent concern: that our problem will be a shortage of workers. Granted, over the past years, the demand for labour from employers has grown faster than the supply of labour, such that labour markets have tightened. This is manifest in a historically low rate of unemployment and a high job vacancy rate. However, we estimate that over the next decade, taking into account demographic trends and planned immigration, the supply of labour will grow fast enough to meet demand. This will require efforts, for example to retain more older workers in the labour force, but our challenge is not one of aggregate supply.

The task is equipping our workers, including immigrants, with the right skills and the right capital to ensure that we meet the qualitative needs of employers, and that we raise productivity levels. On skills, there is cause for concern that shifts in the inflows of economic immigrants by program stream over the past years has coincided with a decline in the level of skills. While it is sensible that immigration policy help address current labour shortages, this cannot obscure the fact that unless economic immigration brings high-skilled workers, it will not help raise income per capita.

… and Investment, Innovation and Productivity Growth

Canada under-invests in tangible and intangible capital. Non-residential investment, as a proportion of GDP or per worker, is below the historical average. Compared with the United States and the average of Organization for Economic Cooperation and Development member countries, our investment gap is large and it has widened over the past years.

In the last quarters, there has been some pick-up in investment in structures (e.g., non-residential construction), but for machinery and equipment and intellectual property products, investment has been sluggish or even declining. The recovery from COVID has been job rich, but productivity poor.

While short-term conditions may not support a boost of investment over the next few quarters, governments and businesses should be focused now on raising investment as a share of our national income.

In Budget 2023, the Government of Canada doubled down on an industrial policy for a clean economy by introducing or expanding tax credits, subsidies and financing vehicles for investment in EV supply chains, clean electricity, hydrogen, carbon capture, utilization and storage, clean fuels, and clean tech and manufacturing. Measures responded in part to the U.S. Inflation Reduction Act and aimed not only to accelerate the energy transition, but also to prevent an outflow of capital.

The federal measures are material and they may move the needle on investment, but there is no certainty. There is market and regulatory risk. Governments and businesses have to align on a plan for execution.

Moreover, investments in the clean economy will have to be advanced on a path that will maximize value earned by Canada through the energy transition. This means addressing energy security for Canada and its economic partners, and realizing value from our supply of hydrocarbons. It also means generating value from our innovation, intellectual property and services in the global energy industry. We can monetize our expertise beyond producing and selling energy products.

Even if successful, the energy transition will not resolve our investment and productivity gaps. There needs to be an economy-wide effort and this cannot be engineered by multiplying tax credits and subsidies.

Governments—federal and provincial—have to create a framework that will enable competition and market incentives to drive investment and innovation. Governments have to consult, engage with businesses, be responsive to global forces, and challenge vested interests and policies that can hold back competition and breed complacency.

Rules and tax structures need to be adapted to a world that is rapidly expanding the potential and applications of digitalization, where a rising share of economic value is generated by intangible assets.

Some initiatives are underway. They need to be pursued with vigour and a sense of urgency: a review of our competition policy, a modernization of privacy and data management legislation and steps to accelerate digitalization in the financial services industry, including modernization of payments and open banking. Markets demand agile regulation and collaboration with global partners.

It is time to take a hard look at the structure of the tax system. We need more investment and proportionately less consumption. While tax reform is a perilous political exercise at the best of times, Canada will benefit from an informed discussion of how tax is affecting our economy.

Our internal market is a regulatory morass. Provinces are in the driver’s seat of the Canadian Free Trade Agreement and they should demonstrate far greater ambition in breaking down long-held, parochial barriers.

The Opportunity for Businesses

Our world is changing and it is uncertain. With still high inflation and interest rates, the prospect for the short term is modest growth. Businesses have to continue to assess and manage risks carefully.

Capitalizing on change requires that businesses invest a larger share of their retained earnings and pursue with resolve their place in the energy transition and the digitalization of the economy, mindful of a new, more fragmented world.

Critically, businesses have to engage with governments on executing investment strategies and on helping to create a policy framework for skills development, competition, investment, innovation and productivity growth.