Why the US economy is thriving while the Canadian economy is faltering

Why the US economy is thriving while the Canadian economy is faltering

Both the Bank of Canada and the US Federal Reserve began raising interest rates in March 2022. Both tightened monetary policy at the fastest pace in decades. In Canada, this has pushed the economy to the brink of recession. South of the border, the American economy is defying gravity.

The differences in economic performance have become increasingly stark in recent months. Canadian consumers are cutting back on their consumption while Americans continue to splurge. American companies are investing in buildings and equipment, building inventories and bringing in new workers, while Canadian companies are withdrawing and preparing for a period of slow growth.

The picture becomes clearer when you look at GDP. Canada’s GDP contracted between April and June and then stalled during the summer and early fall. In the United States, GDP grew at an annual rate of 2.1 percent in the second quarter, then accelerated to a whopping 4.9 percent in the third quarter.

What explains these divergent paths? Inflation has followed a similar path in both countries, rising to its highest levels in four decades in the summer of 2022, then falling to between 3 percent and 4 percent in recent months. Interest rates have risen sharply in both; The interest rate is actually half a percentage point higher in the United States than in Canada.

But interest rates are more influential in Canada, due to higher household debt burdens and mortgages that are renewed more quickly. On the other hand, the US government runs a relatively much larger deficit and pumps more money into the economy. Productivity in the United States is sky-high even as it declines in Canada, which adds to America’s superior performance.

Here are the main reasons why Canada and the United States are heading in different directions, and what that means for interest rates.

Canadian families have been hit hard by interest rates

When interest rates rise, debt levels matter a lot. More money going toward interest payments means less spending on other goods and services. Canadians are deeply indebted.

Most of this is housing debt. In the United States, housing prices collapsed during the 2008 financial crisis, and American families spent the next decade reducing their debt. In Canada, housing prices continued to rise, and with them the bulk of mortgage debt.

Canadian household debt reached 102 per cent of GDP in the first quarter of 2023, according to the Bank for International Settlements. In the United States, the percentage reached 74 percent.

“Even before the pandemic, even before this rise in interest rates, Canadians were spending about 15 cents of every dollar after taxes (debt service), and Americans were spending about 10 cents on the dollar,” said Avery Shenfeld, chief economist at the Bank of Canada. . Imperial Bank of Commerce. “So the starting point was the higher interest burden, which is a burden that rises more steeply in Canada than in the United States.”

The reason interest payments rise more quickly in Canada has to do with how mortgages are structured. American homebuyers typically get 30-year mortgages, allowing them to lock in interest rates for an extended period of time. In Canada, most mortgages reset every five years. This means that rising interest rates can be felt relatively quickly.

Since the Bank of Canada began increasing interest rates in the spring of 2022, about 40 per cent of Canadians with mortgages have seen their monthly payments increase. This percentage will rise significantly over the next few years.

A report released by the Royal Bank of Canada last week estimates that about $900 billion worth of mortgage loans at Canadian charter banks — roughly 60 per cent of the outstanding mortgages on their books — will be rolled over between 2024 and 2026.

Depending on the path of interest rates, average monthly payments on these mortgages could jump by 32 percent next year, and by as much as 48 percent in 2026, the report estimates.

In sum, Canadian homeowners with mortgages (about 35% of all Canadian households) face larger and more immediate payment shocks than their American counterparts. This feeds into the broader economy through several channels.

“It’s not just that Canadians are spending more on interest payments. They’re also choosing to save more of their after-tax income to prepare themselves for those higher payments to come,” Mr. Shenfeld said.

Washington’s most aggressive fiscal policy

While American households spend more than their neighbors to the north, so does the US government.

Both Canada and the United States implement stimulative fiscal policies, but at vastly different levels. Ottawa is expected to run a deficit of more than 1 per cent of GDP this year, but Washington’s deficit is closer to 6 per cent. In the third quarter, US federal spending rose 5.5 percent annually, making it one of the fastest growing sectors of the economy.

Three US programs in particular have stimulated growth: the 2021 infrastructure bill, last year’s inflation reduction law, and a bill supporting the semiconductor industry.

This is seen in significant spending by companies on building factories, which has risen 150 per cent in inflation-adjusted terms since the start of 2020. In Canada, investment in factory building has risen only slightly over the same time frame.

“Whether you look at direct government spending or just industrial policy stimulus, the United States runs a much more stimulative fiscal policy than Canada,” says Sal Guatieri, chief economist at the Bank of Montreal.

Canada has its own industrial policy, such as efforts to attract electric battery manufacturers, but the pace of rollout has been slower.

“Much of the corporate tax measures announced by Canada have yet to be determined,” said Rebecca Young, an economist at Scotiabank.

It’s not that Ottawa is strict. General government spending at all levels of government in Canada has grown nearly twice as fast as in the United States since before the pandemic. It’s just that Canadian governments allocated their spending in the early stages of the pandemic recovery, when lockdowns were severely limiting growth, Ms. Young said.

However, while US fiscal policy is helping to boost growth south of the border, it is also causing a headache for the Fed by increasing inflation in that country.

“It produces excellent economic growth but at the peak of the economic cycle when the United States does not really need it and monetary policy does not welcome it,” Mr. Guatieri said.

Low productivity is a drag on the Canadian economy

Economists and policy watchers have been concerned about Canada’s weak productivity for years. Now, this is exacerbating the economic divergence between Canada and the United States

Productivity measures economic output per hour worked. If productivity were constant, Canada’s rise in population – and the increased supply of workers and demand for goods and services that come with it – would be expected to boost growth. But productivity fell in 11 of the past 12 quarters.

On the other hand, productivity in the United States rose in the third quarter by 4.7 percent, the fastest pace in three years.

The decline in Canadian productivity reflects weak business investment in machinery and technology that would help workers do their jobs more efficiently.

“How do you explain your economy faltering in an environment where the population growth rate is 3 percent,” Mr. Guatieri said. “Until we turn that around, it’s going to be a problem for the Canadian economy.”

What does this mean for interest rates?

Many economists believe the Bank of Canada and the Federal Reserve are done raising interest rates, although the strength of the US economy increases the odds that the Fed will raise rates again. Speculation on Bay Street and Wall Street is turning to when central banks might start cutting interest rates.

The relative weakness of the Canadian economy suggests the Bank of Canada will act first, as Mr. Shenfeld said: “We’ve already been through two quarters of a pause in growth that has yet to kick in in the U.S., so in all likelihood, we’ll get some rate relief before… For the Americans to see that.”

Mr. Shenfeld’s team at CIBC expects the first rate cut from the Bank of Canada around the middle of next year, followed a few months later by the Federal Reserve. Interest rate swap markets, which capture market expectations about monetary policy, are pricing in cuts by the two central banks starting next summer.

If the Bank of Canada moves first, it could put downward pressure on the Canadian dollar. But Mr. Shenfeld said that shouldn’t be a big problem.

“We expect to see a little bit of currency weakness. But I don’t expect the Canadian dollar to go into a free fall, as long as the market still expects at that point that the Fed will start cutting interest rates soon enough.”

    (Tags for translation)Canada

You may also like...

Leave a Reply

Your email address will not be published. Required fields are marked *