Emerging economic might – but no rate hike in sight

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Guess which country is poised to lead the G7 in economic growth this year?

If you said, "The United States! Trumptopia! Make America great again!," you're wrong. But it's an understandable mistake – that was the slam-dunk answer for so long, and it's hard to let these things go.

Just as it's hard to wrap your head around the new G7 growth leader: Canada.

Yes, while our very own Bank of Canada was busy highlighting the undeniable economic divergence between our two countries ("in contrast to the United States" has been a recurring phrase in the central bank's communications over the past few months), Canada's pace of growth has caught up to that of its neighbour and edged past it.

Fourth-quarter real gross domestic product growth in Canada (2.6 per cent annualized) came in well ahead of U.S. growth (1.9 per cent), and the economic indicators to date suggest Canada beat the U.S. in the first quarter of 2017, too. The median forecast among economists surveyed by Bloomberg has Canada and the U.S. dead even for growth in 2017, at 2.2 per cent, well ahead of the rest of the G7. While economists have been trimming their U.S. growth expectations, they have been bumping up their Canadian forecasts.

(Canada's first GDP report of the year, the monthly data for January, comes out Friday.)

For Canada, a lot of factors have been falling into place to feed improved growth. Trade is picking up. Commodity prices have recovered. Business investment is turning upward. Employment is surging. And the impact of government stimulus spending is increasingly taking hold. The impression is that the Canadian economy is finally shaking off the shackles of the oil shock, which have held it back for the past two years, and may be about to make up for lost time.

For the U.S. economy, by contrast, relatively tame economic data have raised questions about how much upside is left in the U.S. expansion – which, after eight years, may be running out of runway. The 4.7-per-cent unemployment rate, the lowest in almost a decade, suggests the economy is already very close to full capacity.

A near-capacity economy means there's limited room for President Donald Trump's promised fiscal stimulus to increase the pace of growth – if that stimulus comes at all this year, given the infighting and general confusion in Washington.

This shift of the relative momentum of the two economies does pose something of a dilemma for the Bank of Canada. While its U.S. counterpart, the Federal Reserve, has raised interest rates twice in the past three months and looks poised to raise them more before the end of the year, Canada's central bank looks glued to the sidelines until the second half of 2018. The bank's main justification for that policy divergence with the U.S. has been the economic stories of the two countries. That's becoming a harder argument to make as Canadian growth catches up to, and maybe even passes, that of its neighbour.

"While the BoC remains steadfast in its view on the huge divergence between the U.S. and Canada, the GDP data on the ground are about to deliver a very different message," said Bank of Montreal chief economist Doug Porter in a research note last week, adding that the shifting growth trend "raises doubts over how long Bank of Canada policy can drift from the Fed's lead."

But listening to Bank of Canada Governor Stephen Poloz, the bank isn't going to be easily swayed from its policy divergence. "I think it would be odd to forget about all the downside risks just because a couple of data points came in a little bit better than expected," he said at a news conference Tuesday.

There's an important distinction to be made – one Mr. Poloz most certainly makes – between the pace of economic growth and the level of the economy. When the Bank of Canada talks about the Canada-U.S. economic divergence, it's not so much about which is growing faster but about the fact that the U.S. recovery is far closer to the finish line than Canada's. The oil shock put Canada's recovery a year or more behind schedule relative to the U.S. recovery; while the U.S. is near full capacity, Canada still has considerable excess capacity to absorb – what it calls the "output gap."

Canada would need to sustain consistent growth firmly above expectations for that output gap to close faster than the Bank of Canada expects, which would be the impetus for it to change its tune on rate hikes. And Mr. Poloz is going to need a lot more convincing on that front.

"We've had positive data points in the past three years, too, and they didn't last. So we're being very cautious," he said.

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