While economic recovery from the pandemic to date, internationally and in Canada, has been uneven and bumpy, a large share of output and jobs have been regained, and the prospects for advanced economies are strong.
If immediate attention must still be focused on overcoming the pandemic durably, the time is right for Canada to look beyond COVID, and to articulate and execute a strategy for investment and long-term improvement in our competitiveness, productivity, and standard of living.
In our baseline scenario, on the assumption that the pace of vaccination is maintained, if not accelerated, we expect the recovery in advanced economies to shift into higher gear in the second half of 2021, before easing gradually during the next two years. Output would return to its pre-pandemic level by the third quarter of 2021, and back to its pre-pandemic trend level by the end of 2022.
These near-term prospects are considerably improved since last fall. A stronger U.S. economy, aided by larger fiscal stimulus and a faster roll out of vaccines than we assumed, underpins a more positive outlook.
For Canada, similarly, we expect that growth will accelerate in the second half of 2021, before slowing during the next two years. Real GDP would grow 5.5% during 2021 (i.e., between the fourth quarter of 2020 and the fourth quarter of 2021), 2.6% during 2022, and 1.9% during 2023.
Several factors will support the Canadian economy in getting back to its potential in the second half of 2022, and to exceed it slightly in 2023: improved household confidence and spending; strong U.S. demand for our exports, including tourism; high commodity prices; the response of business investment to the improved outlook; and continued, overall accommodative financial conditions. This will be mitigated, but only in part, by reduced fiscal support from governments, a strong Canadian dollar and a shortage of industrial inputs and labour in some sectors of the economy.
The evolution of the pandemic continues to represent the predominant risk to the global and Canadian economic outlooks. Sustained vaccination and effective public health measures, including at our borders, are necessary to contain the pandemic durably. Indeed, no solution will be definitive until there is wider global success in managing and hopefully eradicating COVID-19.
The second key risk is inflation and interest rates. Buoyant growth of demand for goods in the United States and China has already stimulated demand for industrial inputs and pushed up the prices of commodities. Tightness in supply chains and adjustment to the recovery has also resulted in sharp rises in the prices of some intermediate inputs, from shipping to semi-conductors.
While there is much uncertainty about how persistent such cost pressures will be, on balance we expect that they will start to ease by the end of 2021. Against our outlook for the U.S. economy, we think that a “data-dependent” Federal Reserve, applying its new framework, will begin to taper bond purchases in the first half of 2022, and finally begin to raise the policy rate by the end of 2022.
There is, however, a risk that U.S. inflation rises more, and for longer, than anticipated because of more persistent cost pressures and/or overheating of the economy. This could lead to higher interest rates in 2022, and slower than projected growth thereafter. Indeed, there is a serious debate underway regarding the prospects that trend inflation in advanced economies could be higher in the medium term than has been experienced in the last two decades of generally below-target inflation.
Against this backdrop, we propose in this outlook some planning assumptions for businesses to the end of 2023, including GDP growth, inflation, and interest rates in the United States and in Canada.
Consistent with our baseline scenario, total employment in Canada is expected to be back to the pre-pandemic level as early as the end of this year. By the second quarter of 2023, the employment rate and the unemployment rate may also be expected to return to their levels of February 2020.
In Budget 2021, the Government of Canada initiated a tapering and adjustment of emergency programs introduced during the pandemic. Given the robust recovery, the distorting effects of interventions if prolonged, and the large costs of the programs, this is broadly appropriate.
The disruption in the labour market caused by the pandemic was sharply differentiated by sector and by segment of the labour force. Its impacts will be felt longer by more vulnerable workers. There will also be permanent changes in the way we work, for example with more Canadians expected to continue working from home, at least for part of their work week.
Drawing lessons from the pandemic, and looking beyond at the changing nature of work, labour market policies require heightened attention to foster growth and inclusion.
In particular, the pandemic accelerated the structural trend of loss of lower-skilled jobs to automation. The need is greater than ever for a framework of life-long learning and skills development that encompasses early learning, education (literacy skills and micro credentials), apprenticeship and on-the-job training, and the re-skilling and upskilling of workers.
Unfortunately, Canada historically has under-invested in skills development. In the public sector, there is no standardized report card publicly available on the success of existing skills training programs at federal and provincial levels. In the private sector, hiring requirements and training programs typically do not favour acquisition of experience and skills by the most vulnerable workers. Numerous reports, and an emerging consensus among experts, identify avenues for improvement.
The pandemic has also added to pressure for Canada to enhance access to childcare. Low-wage, young female workers were among the hardest hit by the pandemic. Many exited the workforce to care for their children.
A Canada-wide Early Learning and Child Care Plan represented the most significant long-term commitment in federal Budget 2021. While the proposed new funding is significant, the details of implementation are not tied down. The goal of 50/50 federal-provincial cost-sharing and the intention to apply federal standards for delivery mean that reaching agreement with provinces will be a daunting task. The best approaches to support long-term growth would address not only the needs of working parents, but also the early development needs of children.
Our last outlook proposed two fiscal anchors for governments to ensure fiscal sustainability: a declining debt-to-GDP ratio; and a 10% rule under which program spending should be restrained so that the projected ratio of debt service costs to revenues does not exceed 10%.
Taking into account debt accumulated during the pandemic, the current fiscal plans of governments, and reasonable assumptions for growth and interest rates, we conclude that the federal fiscal framework is unlikely to be sustainable. The sustainability of national finances, including the budgets of federal and provincial governments, is even more tenuous.
Collectively, federal and provincial governments must publicly acknowledge that if the quality of public services (including income transfers) is to be even maintained, let alone improved or expanded, tax increases will be required. In the long run, fiscal sustainability depends also critically on economic growth, which in turn depends on investment and productivity growth.
With governments and businesses focused to date on reopening the economy and recovering losses of output and jobs, there has been lesser attention on the rebuilding of our economy for a post-COVID world.
While Canadians understandably may wish after a historic crisis for the economy to get back to normal, and for businesses and workers to enjoy a greater measure of security, there is, in fact, no comfortable steady state ahead. Looking beyond COVID, Canada has to reverse two trends that pre-dated the pandemic, and that, left unchecked, will be adverse to our wealth and prosperity.
The first trend is declining productive investment as a share of our economy, which has been significant since the global financial crisis. The second trend, in part the natural consequence of the first, but also longstanding and the result of many factors, is a gradual erosion of our position in global markets.
The two trends together result in higher net borrowing from the rest of the world.
Thus, it is a priority for Canada to allocate a larger share of economic activity to investment in the factors of production—physical, human, and intangible capital—that will enable our economy to perform better in global markets. This will be aided by a growth strategy for the country.
A growth strategy is not old-style industrial policy, with heavy intervention and spending by government in every sector of the economy. At its core, a successful strategy needs to be one which is easily understood, represents a consensus between policy makers and the other major actors in the economy, and can be counted upon to last through the medium term and even beyond.
At a more granular level, a strategy requires an assessment of structural policies such as competition, taxation (tax rates and structure of the system), regulation, intellectual property, international trade and investment, as well as targeted initiatives to support adjustment to change.
There have already been many contributions, including from private sector leaders, to the development of a strategy. What is required now is a clear articulation, ongoing public and private sector engagement, and a focus on execution.
A growth strategy must be responsive, in particular, to two global forces: climate change and the digitization of the economy.
On climate, Canada must not only pursue domestic emission targets, it must seek sources of competitive advantage as the global energy system and economy drive toward lower and ultimately net-zero emissions. This includes decarbonization of our oil and gas industry in a manner that realizes the value of our resources, and that creates opportunities for future exports of energy solutions. Similarly, our motor vehicle and parts industry must situate its future in global supply chains for smart, clean vehicles. Our approach to climate can fit in a commitment to take the initiative on ESG, thus also addressing the evolving expectations of investors and consumers.
Similarly, our economy must take the full measure of the impact of digitization across the economy, and the value of technology platforms and data for the generation of wealth and prosperity. The digital economy and its winner-take-all forces require that there be concerted effort through competition, investment, intellectual property and data management policy frameworks to create the space for Canada-based firms to emerge, grow and capture global market share.
A growth strategy will be informed by, and then help guide, our relationships with key global economic partners.
Despite many challenges, and irritants past, present and future, there remains no relationship more important to Canada than the one with the United States, and no economic, policy and business signals more germane for us than those that come from south of our border. In its first months, the Biden administration has put in motion ambitious plans that create a new and evolving context for Canadian governments and businesses on a least five fronts: the macroeconomy, competitiveness, taxation, climate, and international relations. On each of these fronts, there are opportunities for Canada, some potential hazards, and areas for cooperation. Managing the relationship productively, including on trade, will not be easy, but it is a sine qua non for any growth strategy.
The global trading system is at a critical juncture. The pandemic has highlighted the fragile state of global supply chains and a need to make them more resilient. The World Trade Organization (WTO) is struggling to restore both its negotiation and dispute settlement functions. The Biden administration’s trade policy is still in its formative stages. Canada’s major partners—from China to the United Kingdom—are all grappling with how to manage their trade agenda in this evolving context.
As the rules of global trade are negotiated, our businesses not only have to adapt their business strategies and investment plans for greatest advantage, they have to engage with governments in shaping our trade agenda. At this time, priorities for Canada include the continued implementation of the Canada-United States-Mexico Agreement (CUSMA), reform in the WTO for a well functioning multilateral trading environment and the diversification of our trade to take advantage of new growth opportunities, geographically and sectorally.
Expanded investment and improved global trade could help drive long-term growth and ensure, well beyond COVID, and beyond what is now a strong recovery, rising incomes, improved balance sheets for governments, businesses and households and better standards of living for Canadians.