The Bank of Canada's economic wild card: business investment

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The Bank of Canada was able to fill a big hole in its economic forecasts Wednesday – namely, the contribution of the federal government's stimulus spending to the equation. But there's still another spending vacuum holding back its forecasts, and this one presents an even greater uncertainty for economic growth and the bank's interest-rate policy.

The big wild card is business investment. Its shifting, ill-formed shadow is all over the central bank's latest quarterly Monetary Policy Report.

Business investment is the key contributor to the persistent weakness holding back the bank's economic-growth forecasts. It triggered a downgrade to the bank's estimate of the economy's potential output – implying an important shift in expectations for the future trajectory of rate increases. And its anticipated recovery fuelled by non-resource sectors – the timing and extent of which it could hardly sound less certain – has the potential to override much of the bank's current outlook.

At least the Bank of Canada got over its first big forecast uncertainty of 2016: Thanks to last month's federal budget, the bank was able to incorporate the government's fiscal stimulus spending into its outlook. Indeed, the boost from greater government spending and middle-class tax cuts were sufficient to lift the bank's 2016 gross domestic product growth forecast to 1.7 per cent, up from 1.4 per cent three months ago despite an otherwise weakening of the bank's outlook outside of the government contribution.

The Bank of Canada now believes the spending in the energy sector – which, before the oil crash, was the biggest single contributor to the country's business investment – will slow even more severely this year than it previously estimated, down an additional 32 per cent after the estimated 40-per-cent tumble last year.

The deepening business-investment slump prompted the central bank to cut its already tepid estimate of the economy's potential output growth – the amount of productive capacity the economy is capable of adding. It now thinks potential output will grow by only about 1.5 per cent both this year and next.

Incongruously, this weakness actually implies that interest-rate increases could come sooner, rather than later. The Bank of Canada raises interest rates when it becomes concerned that inflation pressures are building – and that happens on a sustained basis when the gap shrinks between the economy's level of production and its total capacity (this is known as the output gap). Due to the slower potential output growth, the bank now predicts the output gap could close some time in the second half of 2017, rather than the end of 2017 as it had previously forecast.

This suggests the bank will need to start raising interest rates roughly a quarter earlier than previously thought, although the first hike is still probably more than a year away. On the other hand, though, slower growth in output could also mean that interest rates will cap out at a lower level than previously thought – perhaps tilting it closer to the lower end of the 3- to 4-per-cent range the bank had talked about prior to the oil shock. Both expectations are a big deal for the bond and currency markets.

But the bank readily admitted that its outlook on business investment is riddled with uncertainty. Indeed, it sees plenty of signs that businesses outside of the battered resource sector are approaching full capacity and are looking to ramp up their spending to expand their businesses. And there could be much more to come.

"Later this year, the natural sequence of higher non-resource exports and a tightening of capacity constraints should lead to higher investment and employment in the non-resource economy, and therefore growing capacity," Bank of Canada Governor Stephen Poloz said in a news conference following the release of the MPR. "Looking beyond the projection horizon, growth in potential output overall should pick up again."

The bank isn't ready to count on it. It has been burned before in anticipating this non-resource expansion.

"We thought it was under way a year ago, and then it faltered," Mr. Poloz reminded reporters. "It's been a two-steps-forward, one-step-back process."

Mr. Poloz noted that companies in many sectors look ready to invest in new capacity; they have a growing need to invest, but that's not the same as investing. There are signs – non-resource investment numbers have been improving, and Mr. Poloz cited Loblaw Cos.' announced expansion this week as a concrete example – but the bank needs more convincing.

If the wave of non-resource investment takes hold, it would propel economic growth. But it would also add capacity to the economy, thus potentially extending the time frame before the output gap closes, inflationary pressures build and interest-rate increases become necessary.

"There is more than the usual degree of uncertainty around that timing," Mr. Poloz acknowledged. "That window is highly subject to change."

And unlike the hole left in the bank's previous forecast from the government-spending uncertainty, there's no clear finish line for when the business-investment question will be cleared up. From everything the bank is saying, it sounds like its forecasts, and by extension the interest-rate outlook, will be up in the air until we see firmer proof of non-resource investment.