mortgage intelligence monetary policy report

8/9/2019 Mortgage Intelligence Monetary Policy Report

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MONETARYPOLICY

REPORT

January 2015


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The Monetary Policy Report is available on the Bank of Canadas website atbankofcanada.ca.

For further information, contact:

Public Information

Communications Department

Bank of Canada

234 Laurier Avenue West

Ottawa, Ontario K1A 0G9

Telephone: 613 782-8111;

1 800 303-1282(toll free in North America)

Email:[email protected]; Website: bankofcanada.ca

ISSN 1201-8783 (Print)

ISSN 1490-1234 (Online)

Bank of Canada 2015

Canadas Inflation-Control Strategy1

Inflation targeting and the economy

th Bns mn is o conuc monr polic o pro-

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1 See Joint Statement of the Government of Canada and the Bank of Canada on the Renewal of the Inflation-Control Target(8 Novmbr 2011) n

Renewal of the Inflation-Control Target: Background InformationNovember 2011, which r boh vilbl on h Bns wbsi

2 Whn inrs rs r h zro lowr boun, iionl monr sing o chiv h inion rg cn b provi hrough hr unconvn-

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n h principls guiing hir us r scrib in h annx o h april 200 9 Monetary Policy Report
http://www.bankofcanada.ca/http://www.bankofcanada.ca/http://www.bankofcanada.ca/http://www.bankofcanada.ca/http://www.bankofcanada.ca/


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The recent weakness in oil ... is likely to boost globalgrowth but to moderate growth and inflation in Canada,

even though the effects should be tempered by exchange

rate depreciation and stronger non-energy exports.

Stephen S. Poloz

Governor, Bank of Canada

Opening Statement at

the press conference

following the release of the

Financial System Review

Ottawa, Ontario

10 December 2014


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Contents

Global Economy 1

Globl oil prics 2

Non-nrg commoi prics 4

Lowr oil prics boos globl civi 5

Uni Ss 6

Ohr rgions 7

Canadian Economy 9

Rcn inion 10

Cpci prssurs 12

Lowr oil prics wigh on h Cnin conom 14

Businss x invsmn 16

Non-nrg xpors 18Houshol spning 19

Inion 20

Risks to the Inflation Outlook 23

Appendix: The Impact of Lower Oil Prices

on the Canadian Economy 25


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Global EconomyOil prices have plummeted over the past six months. Lower oil prices areexpected to boost global economic growth while widening the divergencesamong economies. These developments are taking place against thebackdrop of a modest pickup in global growth, as headwinds from ongoingdeleveraging and lingering uncertainty gradually abate.

Within this mixed global picture, the main area of strength is the UnitedStates, Canadas largest trading partner. Economic growth in the UnitedStates is expected to become increasingly self-sustaining, further propelledby the large positive impact from oil-price declines, despite the drag fromthe appreciation of the U.S. dollar. In other advanced economies, particu-larly the euro area and Japan, growth is expected to remain weak despiteadditional policy stimulus, as the headwinds from deleveraging and uncer-tainty dissipate gradually. Those headwinds are also expected to temperthe positive effects of lower oil prices on advanced economies. In the restof the world, GDP growth is expected to be held back by the negativeeffects of lower oil prices on oil-exporting countries; however, growth shouldstrengthen gradually through 2016 as foreign demand in advanced econ-omies picks up and growth-enhancing structural reforms are implemented.

Taking these various countervailing factors into account, the Bank antici-pates a pickup in global economic growth to about 3 1/2 per cent over thenext two years, a similar growth profile to that presented in the October2014 Monetary Policy Report(Chart 1and Table 1).1

1 This growth profile is slightly softer than the latest assessment from the International Monetary Fund.

l l i i

Source: Bank of Canada Last data plotted: 2016

0

1

2

3

4

5

6

2010 2011 2012 2013 2014 2015 2016

%

Pre-crisisaverage2000-07

Chart 1: Global economic growth is expected to pick up gradually

Year-over-year percentage change

Forecast

GLOBAL ECONOMY 1BaNk Of CaNada MONetaRy POLICy RePORt JaNUaRy 2015


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Global oil prices are at a five-year lowGlobal crude oil prices have fallen by more than 40 per cent since the

October Report and by more than 55 per cent since their recent peak inJune 2014 (Chart 2). Until mid-2014, oil prices were fairly stable, since theunexpectedly rapid increase in North American production, especially fromU.S. shale oil, was roughly offset by unplanned outages elsewhere in theworld. In the second half of 2014, however, some of these outages ended,while the supply of U.S. shale oil continued to grow (Chart 3). At the sametime, global oil demand has been repeatedly revised down. These forces havedriven global oil prices down to their lowest level in more than five years.

By convention, the Bank assumes that energy prices will remain near theirrecent levels. The prices for Brent, West Texas Intermediate (WTI) andWestern Canada Select (WCS) in U.S. dollars have averaged roughly $60,$55 and $40, respectively, since early December.

The near-term risks to the assumption for oil prices are skewed to the down-side. Prevailing prices are weaker than the Banks base-case assumption,and production growth could remain strong over the coming months, owingto past investment and hedging, as well as ongoing price competition for

il i

Note: WCS refers to Western Canada Select and WTI refers to West Texas Intermediate.

Source: Bank of Canada Last observation: 16 January 2015

WCS crude oil WTI crude oil Brent crude oil

25

50

75

100

125

150

2010 2011 2012 2013 2014

US$/barrel

Chart 2: Global prices for crude oil have plunged

Daily data

October Report

Table 1:Projection for global economic growth

Share of real globalGDPa(per cent)

Projected growthb(per cent)

2013 2014 2015 2016

United States 16 2.2 (2.2) 2.4 (2.2) 3.2 (2.9) 2.8 (2.7)

Euro area 12 -0.4 (-0.4) 0.8 (0.8) 0.9 (0.8) 1.2 (1.0)

Japan 5 1.6 (1.5) 0.1 (0.8) 0.6 (0.7) 1.6 (0.8)

China 16 7.7 (7.7) 7.4 (7.4) 7.2 (7.0) 7.0 (6.9)

Rest of the world 51 3.0 (2.9) 2.9 (2.9) 3.1 (3.2) 3.4 (3.4)

World 100 3.0 (3.0) 3.1 (3.1) 3.4 (3.4) 3.5 (3.5)

a. GDP shares are based on International Monetary Fund (IMF) estimates of the purchasing-power-parity (PPP)valuation of country GDPs for 2013 from the IMFs October 2014 World Economic Outlook.

b. Numbers in parentheses are projections used for the Banks October 2014 Monetary Policy Report.

2 GLOBAL ECONOMYBaNk Of CaNada MONetaRy POLICy RePORt JaNUaRy 2015


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of the expected increase in the world oil supply would similarly be uneconom-ical. A decline in private and public investment in high-cost projects couldsignificantly reduce future growth in the oil supply, and the members of theOrganization of the Petroleum Exporting Countries (OPEC) would have lim-ited spare capacity to replace a significant decrease in the non-OPEC supply.

Prices could also rise if OPEC decides to lower its production level. Lastly,geopolitical issues are perennial sources of volatility in oil prices, and supplydisruptions can emerge at any time.

On the downside, further technological advances and cost-cutting measuresby oil-producing firms could lower their costs of production, thereby reducingthe break-even costs of some energy projects. More fundamentally, the struc-ture of the global oil market and the behaviour of producers may change fromwhat has been observed over the past several decades. In addition, ongoinginnovation to improve energy efficiency and environmental regulations coulddampen the demand for oil.

Overall, the Bank views the risks to the US$60 price assumption to be tiltedto the upside over the medium term.

Movements in many commodity prices have been moremodest than those for oil pricesPrices for non-energy commodities have softened modestly, on average,since the October Report, with a pickup in grain prices mostly offsettinglower prices for other commodities.

Prices for base metals such as copper and iron ore have declined furthersince October, with demand growth from China continuing to moderateas the authorities work to rebalance their economy (Chart 5). These pricemovements have generally been less pronounced than those observed in

i

a. The iron ore series represents an index of spot market prices delivered to China, normalized to the

Qingdao Port and 62 per cent ferrous content.

b. WTI refers to West Texas Intermediate.

Sources: Bloomberg and Bank of Canada Last observation: 16 January 2015

Copper Iron orea Lumber WTI crude oilb

40

60

80

100

120

2014 2015

Index

Jan Mar May Jul Sep Nov Jan

October Report

Chart 5: Movements in many commodity prices have been relatively modest

compared with crude oil prices

Index: 1 January 2014 = 100



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oil markets, however, suggesting that recent shifts in global demand are notthe driving force behind the large movements in oil prices. Lumber priceshave also eased somewhat, as is typical during the winter months whenconstruction activity slows.

Overall, prices for non-energy commodities are expected to remain subdued

through the first half of 2015 and then gradually rise as the global economygains strength. This profile is roughly unchanged from the October Report. Still,owing to the sharp downward revision to the outlook for oil prices, the Bankscommodity price index is about 20 per cent lower than in the October Report.

Lower oil prices boost global activityLower oil prices act as a tax cut for consumers and firms by reducing theprices of transportation and other petroleum-related goods and services. Asa result, they are, on net, positive for global economic growth. However, theimpact of lower oil prices is, of course, quite different for net oil exportersthan for net oil-importing countries.

For a large number of advanced economies, as well as China and other oil-importing emerging-market economies (EMEs), the drop in oil prices boostsGDP growth because of an improvement in their terms of trade, gains in realdisposable income for consumers and a reduction in business costs.

In the current economic context, however, the Bank expects that persistentheadwinds and other mitigating factors will influence the extent to whichsome oil-importing countries benefit from lower prices. As a result, the dropin oil prices is expected to be a more modest boon to growth comparedwith past experience. Lingering uncertainty and ongoing deleveraging willlead some consumers to use the gains in disposable income to pay downdebt rather than increase their spending.

In China, the near-term impact of lower oil prices on GDP may be offset by a

reduction in policy stimulus. Weaker oil prices would allow Chinese authoritiesto reduce policy support for growth, while also facilitating further reforms thatwill help rebalance the economy and mitigate risks in the financial sector.

Falling oil prices are a net negative for oil-exporting countries because theycause a deterioration in their terms of trade and weaken investment andgovernment revenues. However, lower oil prices also put downward pres-sure on the currencies of oil exporters, which helps to cushion the negativeimpact on their economies.

In some EME oil exporters, the large decline in oil prices has spurred sig-nificant financial market turmoil, which has led to capital outflows, largeincreases in sovereign spreads, and significant currency depreciation andvolatility in foreign exchange markets. This turmoil has been particularly

acute in Russia, where low oil prices have compounded existing challengesfrom economic sanctions. There is a risk that financial market turbulencecould spread to other oil-exporting nations and even to other EMEs, damp-ening their prospects for economic growth.

The decline in oil prices will push down total inflation everywhere, againsta backdrop of persistent global excess capacity and subdued inflationarypressures (Chart 6). The impact on inflation is especially important for theeuro area, where headline inflation has fallen below zero, increasing the riskthat inflation expectations could become de-anchored.

GLOBAL ECONOMY 5BaNk Of CaNada MONetaRy POLICy RePORt JaNUaRy 2015


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Fundamentals continue to improve in the United StatesU.S. economic activity strengthened through 2014 (Chart 7). Although activitycontinues to rely on ongoing accommodative monetary policy, fundamentalsare improving and should lead to further growth in U.S. private domesticdemand. Stronger business investment is indicative of improved confidence.Credit conditions, other than for housing (for example, for auto financing),have eased considerably. Moreover, in 2015, government spending is

expected to resume growing on an annual basis for the first time in five years.The U.S. labour market has improved. Job gains have averaged close to250,000 per month through 2014; the unemployment rate has fallen; andother labour market indicators, including the Banks labour market indicator(LMI) for the United States, have improved.

The decline in oil prices will provide a further boost to economic activity. Theestimated impact of a decline in oil prices from the June 2014 level of aboutUS$110 to the base-case assumption of US$60 would be to raise the levelof U.S. GDP by about 1 per cent by the end of 2016.

Overall, the combination of the recent stronger-than-expected U.S. growthand lower oil prices, partially offset by the appreciation of the U.S. dollar

over recent months, results in a more positive outlook for the U.S. economythan anticipated in the October Report.

i l i i

Note: Starting in April 2014, Japanese inflation has been adjusted downward by 2 percentage points, based on

Bank of Japan estimates of the effect of the increase in the value-added tax.

Sources: U.S. Bureau of Economic Analysis, Eurostat, Last observations:

Bank of Japan, Japan Ministry of Internal Affairs Euro area and United States, December 2014;

and Communications, and International Monetary Fund Remaining, November 2014

United States Euro area Japan Emerging Asia Latin America

-4

-2

0

2

4

6

8

2009 2010 2011 2012 2013 2014

%

Chart 6: Inflation remains subdued in most regions, notably in the euro areaTotal CPI, year-over-year percentage change



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Since October, the Canadian dollar has depreciated against the U.S. dollar,reflecting the drop in oil prices and the widespread strength of the U.S. cur-rency, but is little changed against the currencies of Canadas other majortrading partners. By convention, the Canadian dollar is assumed to be closeto its recent average level of 86 cents over the projection horizon, comparedwith 89 cents assumed in October.

i i

Note: The Canadian-dollar effective exchange rate index (CERI) is a weighted average of bilateral exchange

rates for the Canadian dollar against the currencies of Canadas major trading partners. A rise indicates an

appreciation of the Canadian dollar.

Sources: Bank of Canada, European Centra l Bank and Bank of Japan Last observation: 16 January 2015

Can$/US$ CERI excluding US$ Euro/US$ Yen/US$

85

90

95

100

105

2014 2015


Index

October Report

Chart 8: Relatively brighter prospects for U.S. growth are reflectedin the broad strength of the U.S. dollarIndex: 6 January 2014 = 100

i i

Source: Reuters Last observation: 16 January 2015

Canada United States Germany Japan Spain Italy

0

1

2

3

4

2014 2015

%


October Report

Chart 9: Interest rates on long-term government bonds in advancedeconomies have declinedYield to maturity on 10-year sovereign bonds



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Canadian EconomyInflation in Canada has remained close to the 2 per cent target in recentquarters. Core inflation has been temporarily boosted by some sector-specific factors and the pass-through effects of the depreciation in theCanadian dollar, which provide an offset to disinflationary pressures fromslack in the economy and the effects of competition in the retail sector.

Total CPI inflation softened noticeably in November, reflecting lower energyprices, and will fall substantially further in coming months.

The large decline in oil prices will weigh significantly on the Canadianeconomy (Chart 10). While real GDP growth has been solid and morebroadly based in recent quarters, near-term growth is expected to slowas investment in the energy sector responds rapidly to lower oil prices. Inaddition, Canadas weakening terms of trade will have an adverse impact onincome and wealth, with implications for consumption and public finances.The negative impact of lower oil prices will be gradually mitigated bystronger U.S. growth, the weaker Canadian dollar and the beneficial impactof lower oil prices on global economic growth. Given the speed and magni-tude of the oil-price decline, there is substantial uncertainty around the likelylevel for oil prices and their impact on the economic outlook for Canada.

l i il i i

Sources: Statistics Canada and Bank of Canada projections

Terms of trade Real gross domestic income (GDI) Real GDP

-8

-6

-4

-2

0

2

4

2012 2013 2014 2015 2016

%

Chart 10: The recent sharp drop in oil prices will weigh significantlyon the Canadian economyYear-over-year percentage change, quarterly data

CANADIAN ECONOMY 9BaNk Of CaNada MONetaRy POLICy RePORt JaNUaRy 2015


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Bearing in mind this uncertainty, in its base-case projection, the Bankexpects that in the first half of this year real GDP growth will slow to about1 1/2 per cent and the degree of excess capacity will widen somewhat. TheBank expects the economy to gradually strengthen, starting in the secondhalf of 2015, with the output gap closing around the end of 2016, a little laterthan was expected in October.

Relative to October, the year-over-year growth rate for real GDP in thefourth quarter of 2015 has been revised down by 0.5 percentage points to1.9 per cent. In the fourth quarter of 2016, growth has been revised up by0.3 percentage points to 2.5 per cent.

While total CPI inflation is projected to fall as a result of the drop in energyprices, and to be temporarily below the inflation-control range during 2015,the Bank anticipates that total CPI inflation will move back up to target thefollowing year. Core inflation is expected to soften in the near term andremain close to 2 per cent over the projection horizon.

Inflation has remained near 2 per cent in recent quartersBoth total CPI and core inflation have hovered near 2 per cent in recentquarters, about 1 percentage point higher than a year earlier. The increasein core inflation over the past year is largely due to some sector-specificfactors and the temporary effects of a lower Canadian dollar.2Even withoutthese factors, there has been a small upward drift in underlying inflation,consistent with the recent trend shown by alternative measures of coreinflation (Chart 11).

2 While meat, communications, and clothing and footwear represent just 12 per cent of the core CPI

basket of components, they account for almost two-thirds of the year-over-year rise in core inflation

since the fourth quarter of 2013.

l i i

a. These measures are CPIX; MEANSTD; the weighted median; CPIW; CPI excluding food, energy

and the effect of changes in indirect taxes; and the common component. For definitions, see:

Statistics > Indicators > Indicators of Capacity and Inflation Pressures for Canada > Inflation

on the Bank of Canadas website.

b. Extracts the component of inflation that is common across the individual series that make up the CPI.

See M. Khan, L. Morel and P. Sabourin, The Common Component of CPI: An Alternative Measure of

Underlying Inflation for Canada, Bank of Canada Working Paper No. 2013-35.

Sources: Statistics Canada and Bank of Canada calculations Last observation: November 2014

Range of alternative

measures of core inflationa

Common

componentb

Target Core CPI

%

2007 2008 2009 2010 2011 2012 2013 20140.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Chart 11: Alternative measures of core inflation have edged up

Year-over-year percentage change, monthly data

10 CANADIAN ECONOMYBaNk Of CaNada MONetaRy POLICy RePORt JaNUaRy 2015
http://www.bankofcanada.ca/rates/indicators/capacity-and-inflation-pressures/inflation/http://www.bankofcanada.ca/rates/indicators/capacity-and-inflation-pressures/inflation/http://www.bankofcanada.ca/rates/indicators/capacity-and-inflation-pressures/inflation/


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Sector-specific factors are temporarily raising core inflation by about0.3 percentage points. Of these factors, the most important are meat andcommunications prices, which are boosting core inflation by a combined0.4 percentage points relative to their historical average contribution(Chart 12). Continued supply constraints for cattle have prevented inflationin meat prices from abating. On the other hand, travel tours prices declinedsharply in November, dampening core inflation by about 0.1 percentage point.

The effect of the pass-through from exchange rate depreciation is estimatedto be currently raising core inflation by about 0.2 to 0.3 percentage points. 3The impact from pass-through is difficult to estimate precisely, for at leasttwo reasons. First, hedging has insulated some prices from immediatelyshowing the full impact of currency movements. Second, it is not easy toseparate the impact on prices of pass-through from the effects of retailcompetition, since both factors tend to affect the same categories of goodswith high import content. Nevertheless, a comparison of price developmentsin Canada with those in the United States supports our assessment of theeffects of pass-through (Chart 13).

Retail competition and continued slack in the economy are having a damp-ening effect on core inflation. The Bank estimates that core inflation wouldbe about 0.3-0.4 percentage points higher without their combined effects.

Total CPI inflation in the fourth quarter of 2014 is estimated to have been0.2 percentage points lower than expected in October. The downwardrevision is due to the weaker-than-anticipated energy prices associated withthe drop in oil prices.4

3 The pass-through to total CPI inflation is estimated to be about 0.4 to 0.5 percentage points.

4 The decline in oil prices since June, measured in U.S. dollars, has contributed to reducing total CPI

inflation by about 0.8 percentage points.

i i

Sources: Statistics Canada and Bank of Canada calculations Last observation: November 2014

Core inflation Core inflation excluding meat and communications

2007 2008 2009 2010 2011 2012 2013 2014

%

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Chart 12: Prices for meat and communications are providingan extraordinary boost to core inflationYear-over-year percentage change, monthly data



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Material slack remains in the economyReal GDP grew more rapidly in the third quarter than anticipated in October,driven by further solid gains in household spending and exports, and arebound in business investment. In the fourth quarter, real GDP is estimatedto have grown by about 2 1/2 per cent.

The net effect of recent stronger-than-expected growth, together with signifi-cant upward revisions to historical data going back to 2011, is that the levels ofreal GDP and potential output in the fourth quarter of 2014 are now estimatedto be 0.9 and 0.7 per cent higher, respectively, than assumed in October.

The three main indicators that the Bank uses to assess overall pressureson production-based capacity in the economy continue to indicate someexcess capacity but provide different signals as to its magnitude (Chart 14).Both the Banks winter Business Outlook Surveyand the statistical measureof the output gap suggest that the gap is quite small, while the structuralestimate of the output gap suggests that the gap is larger, on the order ofabout 1 per cent.5

Many labour market indicators point to significant slack in the economy. Forexample, the structural estimate of the labour input gap is currently around1 1/2 per cent. The Banks comprehensive measure of labour marketperformance (the LMI) continues to fluctuate in the range observed overthe past several years, suggesting both more labour market slack and less

improvement in labour market conditions than indicated by the unemploy-ment rate (Chart 15).6Relative to the unemployment rate, improvement inthe LMI has been held back by other labour market developments: long-termunemployment is still close to its post-crisis peak, average hours workedremain low, and the proportion of involuntary part-time workers continues

5 The structural estimate of the output gap refers to the integrated framework, while the statistical

estimate refers to the extended multivariate filter. For details on these approaches, see L. Pichette, P.

St-Amant, B. Tomlin and K. Anoma, Measuring Potential Output at the Bank of Canada: The Extended

Multivariate Filter and the Integrated Framework, Bank of Canada Discussion Paper No. 2015-1. Both

estimates of the output gap can be found on the Bank `s website at http://www.bankofcanada.ca/rates/

indicators/capacity-and-inflation-pressures/.

6 This indicator is now published on the Banks website.

l l i

-8

-6

-4

-2

0

2

4

%

2007 2009 2011 20132008 2010 2012 2014

-4

-2

0

2

4

6

%

2007 2009 2011 20132008 2010 2012 2014

Canada United States Canada United States

Sources: Statistics Canada and U.S. Bureau of Labor Statistics Last observation: November 2014

a. Durable goods b. Apparel

Chart 13:Canadian prices for durables and apparel have recently increased faster than their U.S. counterpartsear-over-year percentage change, monthly data

http://www.bankofcanada.ca/rates/indicators/capacity-and-inflation-pressures/http://www.bankofcanada.ca/rates/indicators/capacity-and-inflation-pressures/http://www.bankofcanada.ca/rates/indicators/capacity-and-inflation-pressures/http://www.bankofcanada.ca/rates/indicators/capacity-and-inflation-pressures/


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Measures of the utilization of the existing capital stock are less indicative ofexcess capacity, as would be expected, given the destructive forces thataccompany a longer and more persistent recession such as the recent globalrecession.9Capacity utilization in the manufacturing sector increased furtherin the third quarter, to about 84 per cent, above its long-term average of about81 per cent. This elevated level of utilization follows a challenging period ofadjustment for the sector, and is consistent with the manufacturing sectorentering a rebuilding phase. Responses to the Banks winter Business OutlookSurveyindicate that firms benefiting from strengthening U.S. demand andimprovements in exports have started to feel some pressures on their capacity.For example, over the past year, a growing share of exporters have cited

physical capacity constraints as an obstacle to meeting a sudden increase indemand or sales.

Taking into account the various indicators of capacity pressures and theuncertainty surrounding any point estimate, the Bank judges that theamount of excess capacity in the fourth quarter was between 1/4 and1 1/4 per cent. This range suggests about 1/4 of a percentage point lessexcess capacity than was estimated in October for the third quarter.

A lower profile for oil prices will weigh importantly on theCanadian economyThe considerably lower profile for oil prices will be unambiguously negative

for the Canadian economy in 2015 and subsequent years (seeAppendix).

In the near term, real GDP growth is expected to slow to below the growthrate of potential output, and the unemployment rate is expected to rise asinvestment in the energy sector rapidly contracts in response to lower oilprices and as housing market activity in energy-intensive regions slows.Growth in the first half of 2015 is anticipated to average about 1 1/2 per cent,considerably weaker than the growth rate of about 2 1/2 per cent expected inOctober. To illustrate the degree of uncertainty in the base case associatedwith the Banks assumption for the price of oil, if oil prices were to remain

9 For a discussion of capital and labour adjustments through recessions, including rebuilding after a

more persistent and destructive recession, see Box 1 in the October 2014 Monetary Policy Report.

i i i

Source: Statistics Canada Last observation: 2014Q3

L abour productivit y Compensation per hour Unit labour costs

-2

-1

0

1

2

3

4

5

6

2007 2008 2009 2010 2011 2012 2013 2014

%

Chart 16: Growth in unit labour costs remains subduedYear-over-year percentage change, quarterly data



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21/31

i i i

Sources: Statistics Canada and Bank of Canada calculations and projections

GDP growth, at annual rates

(left scale)

Business fixed investment (right scale)

Exports (right scale)

Other components of GDP (right scale)

-1

0

1

2

3

4

5

-1

0

1

2

3

4

5

%

2010 2011 2012 2013 2014 2015 2016

Percentage points

Chart 17: Real GDP growth is projected to slow in the first half of 2015Contributions to real GDP growth; 4-quarter moving average

industries, restrain housing activity in energy-intensive regions and providesome incentives for households whose incomes rely on the oil sector tobuild precautionary savings. In contrast, the manufacturing sector willbenefit from stronger demand in the United States, lower shipping costs andthe weaker Canadian dollar.

If the recent decline in oil prices proves durable, there could be a persistentshift of investment and jobs away from energy-related sectors and regions,thereby reversing some earlier structural adjustment in Canadas economy.

The Banks latest Business Outlook Surveyprovides information about theearly responses of firms to this shock. The balances of opinion on futuresales growth, hiring and capital spending intentions are all lower than inthe previous survey. Businesses also report a higher level of uncertaintyabout the economy. Not surprisingly, responses from firms in the Prairiesare particularly negative. On the other hand, sentiment in the export sectorhas continued to improve, with manufacturers now more positive than othersectors regarding investment intentions and employment.

Lower oil prices will have their largest effect on businessfixed investment

While business investment had been showing some encouraging signs inthe third quarter of 2014, the near-term outlook appears much less positive.The most important near-term impact of the lower oil prices on Canadianreal GDP is expected to be from lower investment in the oil and gas sector,which is now projected to fall by roughly 30 per cent in 2015 and remainbroadly unchanged in 2016 (Chart 18). By itself, this drop would reduceoverall business investment by about 10 per cent.

Interviews with energy firms conducted by Bank staff in November andDecember 2014 suggest a relatively quick investment response to lower oilprices, with firms already scaling back projects planned for 2015 (Box 1).



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23/31

il i


O il and gas sector O ther sectors

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

Percentage points

Chart 18: Investment in the oil and gas sector is projected to fall sharplyBusiness fixed investment, contributions to real GDP growth, annual data

Oil prices are now lower than current full-cycle break-even costs for many

projects.10Financing constraints also appear to be playing an important

role. The negative consequences of the oil-price shock are also likely to

feed through to firms that provide support to the oil sector, including rail

transportation.

With lower oil prices, the growth rates of Canadian energy production

and exports are expected to slow. Energy exports are now projected to

grow at an annual average rate of about 1 per cent, compared with about

6 per cent in 2014.

Non-energy exports are gaining further tractionExports of non-energy goods rebounded in 2014, with continued strong

growth in the third quarter of 2014. Growth in non-energy exports has been

particularly evident in categories that are more sensitive to the exchange

rate (Chart 19). The recovery in non-energy exports is expected to continue

over the projection horizon, with exports stimulated by the lower Canadian

dollar and stronger foreign activity.

Outside the energy sector, there are signs that the hoped-for sequence of

increased foreign demand, stronger exports, improved business confidence

and investment, and employment growth is progressing. Some industries,

such as transportation and manufacturing, will benefit from lower oil prices

through lower input costs, which could stimulate some additional invest-

ment. Moreover, business fixed investment outside the oil and gas sector is

expected to strengthen as the pickup in non-energy exports is increasingly

perceived as sustainable.

However, there is considerable uncertainty about the speed with which this

sequence will evolve and also about how the drop in oil prices could affect

that process.

10 Full-cycle project costs incorporate expenses for the procurement of land, engineering, and the

construction and modularization of infrastructure, as well as project commissioning and star t-up

spending, in addition to operating costs, general and administrative expenses, taxes, and sustaining

capital costs.



24/31

Household spending is expected to slowHousehold spending remained strong in the third quarter of 2014, with fur-ther solid gains in motor vehicle sales and robust housing activity.

Over the projection horizon, consumption growth is expected to slow asthe negative terms-of-trade shock from lower oil prices leads to higherunemployment and restrains income growth and wealth.11In the near term,households will have money saved on energy purchases to reallocate. Withincreased risks of layoffs, those households whose incomes rely on the oilsector will have greater incentives to build precautionary savings or paydown debt. Others may choose instead to increase their spending on goodsand services.

The oil-price shock will also affect housing activity in energy-intensiveregions. There has been a decrease in housing starts and a sharp dropin resales and sales-to-listings ratios in Alberta in December. Near-termhousing activity elsewhere is expected to remain high, supported by verylow mortgage rates, although the extent to which the downturn already

evident in Alberta will spill over into other regions remains to be seen. Onthe whole, residential investment as a share of GDP is expected to declinegradually over the projection horizon.

Household imbalances remain elevated and are expected to edge up inthe near term, given the continued strength of house prices and resaleactivity in some regions.12Energy-intensive regions will be more suscept-ible to declining house prices and rising unemployment rates, which would

11 The impact of the oil-price shock on disposable incomes will be only partly mitigated by some recently

announced federal tax changes.

12 For a more detailed assessment of vulnerabilities in the household sector, see the December 2014

Financial System Reviewat http://www.bankofcanada.ca/2014/12/fsr-december-2014/.

i i

a. Up to November 2014

b. Key categories include industrial machinery, equipment and parts; building and packaging materials; tires,

motor vehicle engines and motor vehicle parts; other electronic and electrical machinery, equipment and

parts; and plastic and rubber products.

c. Key categories include passenger cars and light trucks; intermediate metal products; food, beverage and

tobacco products; farm and fishing products; and basic chemicals and industrial chemical products.

Sources: Statistics Canada and Bank of Canada calculations

Total non-energy

exports of goods

Exchange rate

sensitivebNot exchange

rate sensitivec

0

2

4

6

8

2013 2014a

%

Chart 19: Growth in non-energy exports has been particularly evident

in categories that are more sensitive to the exchange rate

Average annual growth



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26/31

Short-term expectations for total CPI inflation have been revised down con-siderably, but medium-term expectations remain well anchored. Comparedwith October, the January Consensus Economics forecast for total CPIinflation for 2015 declined by 0.8 percentage points to 1.1 per cent. Theforecast for total CPI inflation for 2016 is 2.1 per cent. Results of the Bankswinter Business Outlook Surveyshow that the majority of firms still expectinflation over the next two years to be within the 1 to 3 per cent range, witha shift toward the bottom half of the range. The central tendency is about1 3/4 per cent.

Based on the past dispersion of private sector forecasts, a reasonable rangearound the base-case projection for total CPI inflation is 0.3 percentagepoints.13This range is intended to convey a sense of forecast uncertainty.Fan charts, which are derived using statistical analysis of the Banks forecasterrors, provide a complementary perspective (Chart 22and Chart 23).14

13 See Box 1 in the October 2013 Monetary Policy Report.

14 The fan charts are derived from projection errors for the current quarter to eight quarters in the future.

These errors are based on inflation projections from past is sues of the Monetary Policy Report and

Monetary Policy ReportUpdate, using quarterly data from the first quarter of 2003 to the second

quarter of 2014.

i i

a. CPI excluding eight of the most volatile components and the effect of changes in indirect taxes on the

remaining components


Total CPI Core CPI a Target Control range

-1

0

1

2

3

4

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

%

Chart 21: Total CPI inflation is expected to drop below 1 per cent in 2015Year-over-year percentage change, quarterly data



27/31

il i i i

Source: Bank of Canada

Projection 50 per cent confidence interval

90 per cent confidence interval

2011 2012 2013 2014 2015 2016

0

-1

1

2

3

4

%

Chart 22:Projection for core inflationYear-over-year percentage change, quarterly data

il l i i i


Projection 50 per cent confidence interval

90 per cent confidence interval

2011 2012 2013 2014 2015 2016

0

-1

1

2

3

4

%

Chart 23: Projection for total CPI inflationYear-over-year percentage change, quarterly data



28/31

Risks to the Inflation OutlookThe outlook for inflation is subject to several risks emanating from both theexternal environment and the domestic economy. The Bank judges that therisks to the projected path for inflation are roughly balanced.

The most important risks to inflation are the following:

(i) Stronger U.S. private demandStronger-than-expected private demand in the United States is themost important upside risk to inflation in Canada. Recent momentum,combined with the boost from lower oil prices, could spur even strongeractivity, rekindling animal spirits in the United States. In turn, busi-nesses would increase hiring and investment by more than expected,providing further support for household spending and economicactivity more generally. Robust U.S. activity would generate positivespillovers to growth in the rest of the world, particularly demand forCanadas non-energy exports.

(ii) Two-sided risks to oil prices

Oil prices have fallen sharply since mid-2014, reflecting importantsupply-side developments and lower growth in global demand.There is a risk that oil prices could fall further if major oil producerscontinue to expand supply in a context of moderate global economicgrowth. On the other hand, oil prices could move higher if materialoutages reappear or if declining investment by higher-cost producerssqueezes supply sooner than expected. While lower oil prices wouldbenefit consumers, the effect on Canada would, on balance, benegative, reducing Canadas terms of trade and domestic income.Persistently lower-than-assumed oil prices could also have a materialimpact on investment and activity in the oil sector and the associatedmanufacturing supply chain. A rise in oil prices would mitigate someof the negative impacts that have already occurred.

(iii) Slower growth in emerging-market economies

There is a risk that growth in China and other emerging-marketeconomies (EMEs) could be much slower than expected. There are anumber of possible triggers for this risk, including a housing-inducedslowdown and financial stress in China; a geopolitical event thatimpairs global confidence; or contagion from EME oil exporters,where the drop in oil prices has exposed significant existing vulner-abilities. It is also possible that potential growth in EMEs is muchlower than estimated. A slowdown in EMEs would weigh on U.S. andCanadian economic growth through trade, financial and confidencechannels, and put further downward pressure on commodity prices.

RISKS TO THE INFLATION OUTLOOK 23BaNk Of CaNada MONetaRy POLICy RePORt JaNUaRy 2015


29/31

(iv) Weaker Canadian exports and business investment

Recent data remain consistent with a broad-based pickup in non-energy exports, in line with a continued strengthening of the U.S.economy and the past depreciation of the Canadian dollar. However,reduced capacity in many export sectors may limit the extent to which

exporters continue to benefit from stronger external demand andthe lower Canadian dollar. At the same time, while data for the thirdquarter of 2014 pointed to the beginning of a rebound in businessinvestment, particularly in machinery and equipment, the realization ofa downside risk to exports would also have negative implications forinvestment. The Bank already projects a significant decline in invest-ment in the oil and gas sector in 2015. Investment spending in thissector could be even weaker based on experience during the oil-pricedecline witnessed in 1986, which was similar in magnitude to the cur-rent episode. Together, a decline in exports and business investmentwould pose a downside risk to inflation.

(v) Imbalances in the Canadian household sector

A soft landing in the housing sector continues to be the most likelyscenario, with residential investment expected to gradually decline overthe projection horizon. However, near-record-high house prices anddebt levels relative to income continue to leave households vulnerableto adverse shocks. The precise magnitude of the impact of the fall inoil prices on household income, spending and, ultimately, on existingimbalances is highly uncertain. However, some further increase in thedebt-to-income ratio is likely. A disorderly unwinding of these imbal-ances, should it materialize, could have sizable negative effects onother parts of the economy and on inflation.

24 RISKS TO THE INFLATION OUTLOOKBaNk Of CaNada MONetaRy POLICy RePORt JaNUaRy 2015


30/31

Oil n gs xrcion ccouns or onl bou 6 pr cn

o GdP, bu movmns in oil prics hv signicn

impc on h Cnin conom this is u, in pr, o h

impornc o invsmn in h oil n gs scor, which

ms up bou 30 pr cn o ol businss invsmn

Morovr, sinc Cn is n oil xporr, oil prics hv

n imporn c on omsic incoms n h Cnin

ollr1

In h april 2011 Monetary Policy Report, h Bn ini

v chnnls hrough which movmns in commoi

prics c h Cnin conom (Figure A-1) ting

hs chnnls oghr, h n c o h clin in oil

prics or h Cnin conom is ngiv

Table A-1shows h sim impc o shi in h prico Brn cru oil rom is Jun 2014 lvl o bou US$110

pr brrl o rng o bwn US$50 n US$70, rl-

iv o scnrio in which oil prics rmin US$110

hroughou h projcion ths sims mp o

isol h impc o h oil-pric shi rom ohr shocs

Unrling h ggrg impcs is complx s o jus-

mns cili b h xibili o h Cnin conom

th rsuls rpor hr ssum no monr polic

rspons o h oil-pric shoc2

Terms of trade, income and household expendituresSinc Cn is n xporr o oil, h clin in oil prics

o h US$50US$70 rng cuss Cns rms o r

o ll b bwn 7 n 12 pr cn b h n o 2016 this,

in urn, rucs ggrg incom n wlh, wih gross

omsic incom lling b bwn 33 n 58 pr cn

th irc impc on h rms o r ccouns or mor

hn wo-hirs o his clin Lowr incoms lso l o

1 Oil xpors ccoun or bou 14 pr cn o ol Cnin xpors

2 th bs-cs projcion n h rsuls rom simulions rpor in J dorich,

M k Johnson, R R Mns, S Murchison n y Zhng, toteM II: an

Up Vrsion o h Bn o Cns Qurrl Projcion Mol, Bn o

Cn tchnicl Rpor No 100, Ocobr 2013, llow or polic rspons

o h ruc ggrg mn n inionr prssurs h rsul rom

lowr oil prics

Appendix: The Impact of LowerOil Prices on the Canadian Economy

i l il i

Figure A-1:Oil prices affect the Canadian economy through

several channels

Direct CPI Inflation

Aggregate demandTerms of trade

Commodity supply

Production costs

Foreign demand

Income

Exchange rate

Table A-1:Lower oil prices have a net negative impacton real GDP in Canada

2015Q4 (%) 2016Q4 (%)

Output-1.0

(-0.7 to -1.3)

-1.4

(-1.0 to -1.8 )

Consumption-0.7

(-0.5 to -0.9)

-1.3

(-0.9 to -1.7)

Investment-4.7

(-3.3 to -6.0)

-5.2

(-3.7 to -6.6)

Housing-0.1

(0.0 to -0.1)

-0.6

(-0.4 to -0.8 )

Exports-0.4

(-0.2 to -0.6)

0.1

(0.1 to 0.1)

Note: The bold numbers represent the impact of a decline in oil prices fromUS$110 to US$60, relative to a scenario in which oil prices remain at US$110throughout the projection. The numbers in parentheses represent the estimatedimpacts of declines from US$110 to a range of US$70 to US$50. All of thesescenarios assume no monetary policy response to lower oil prices.


(continued)

APPENDIX: THE IMPACT OF LOWER OIL PRICES ON THE CANADIAN ECONOMY 25BaNk Of CaNada MONetaRy POLICy RePORt JaNUaRy 2015


31/31

appnix (continued)

n incrs in houshol imblncs, sinc h b-o-is-

posbl-incom rio riss b bou 4 prcng poins

Whil h impc on incoms is mos cu in oil-proucing

rgions, svrl mchnisms ius h c hrough hCnin conom:

Lowr lbour mn n wgs in h oil scor spill ovr

ino ohr scors n rgions o som xn

Wr pros in h oil scor vrsl c h invs-

mn porolios o Cnins in ll prs o h counr

Inrprovincil r sprs h cs o slowing oil

scor for xmpl, sims suggs h nrl on-

hir o h mplomn cs rom h oil sns on h

omsic suppl chin occur ousi albr3

frl scl polic nus ispriis in h impc o

oil-pric movmns on irn rgions

Lowr oil prics lso hv irc c on som com-

ponns o h CPI, mos impornl, gsolin, ul oil

n rnsporion In h nr rm, his irc CPI c

booss consumrs purchsing powr, bluning h cs

o lowr incoms Ovr im, howvr, h incom c

omins B h n o 2016, consumpion is bwn

09 n 17 pr cn lowr hn i woul hv bn wihou

h clin in oil prics

Housing is lso wr s rsul o lowr oil prics n

incom Lowr lbour mn in oil-proucing rgions will

n o slow or m vn rvrs migrion prns hhv prvil in rcn rs In, inrprovincil migr-

ion o albr slow shrpl in h hir qurr o 2014,

bor h bul o h clin in oil prics Shis in migrion

prns r lil o rinorc h impc o lowr incoms

on housing mrs in oil-proucing rgions

Business investment, exports and the exchange rateProucion in h oil scor is highl cpil innsiv

Consqunl, chngs in oil-scor invsmn r on o

h mos imporn chnnls hrough which oil-pric shocs

c h Cnin conom Lowr oil prics ruc h

pros ssoci wih oil xrcion, cusing rms o suppl

lss oil o h mr this commoi-suppl chnnl ls

3 Conrnc Bor o Cn, ful or though: th economic Bns o Oil

Sns Invsmn or Cns Rgions, Ocobr 2012

o rucion in proucion, xpors n invsmn in h

oil scor

In conrs, lowr proucion coss or rms h us oil s

n inpu l o ris in pros, oupu n invsmn inh non-oil-rl sgmns o h conom Howvr, his

os is no sucin o prvn ol businss invsmn

rom clining in rspons o lowr oil prics Ovrll, busi-

nss invsmn clins b bwn 37 n 66 pr cn b

h n o 2016 th impc o lowr invsmn on GdP is

mpr b h high proporion o invsmn goos h r

impor rom bro

th xchng r lso pls cnrl rol in h jusmn

o h Cnin conom o n oil-pric shoc Invsmn

in Cn is nnc b boh omsic n orign cpil

Ruc invsmn ls o rop in h n inow o orign

cpil, which, oghr wih lowr oil xpor rvnus, cussh Cnin ollr o wn

Ohr hings bing qul, h wr xchng r urhr

ggrvs h vrs impc on invsmn b ming

impor goos mor xpnsiv Howvr, h xchng

r jusmn lso ms Cns non-nrg xpors

mor compiiv in inrnionl mrs, which booss

sls n, vnull, invsmn Morovr, in h cur-

rn nvironmn, lowr oil prics r mosl h rsul o

bunn globl suppl coniions Oil-pric clins u

o bunn suppl simul conomic civi in Cns

min ring prnrs, proviing urhr boos o orign

mn or Cns non-nrg xpors th ovrllimpc o lowr oil prics on Cnin xpors is mos,

sinc highr non-nrg xpors os lowr nrg

xpors Howvr, h shi in oil prics will n o rw

popl n cpil w rom h oil scor n owr sc-

ors n rgions h bn rom wr ollr, such s

h mnucuring scor in Cnrl Cn

InflationLowr oil prics ruc ovrll mn in h Cnin

conom, lving oupu lowr b 1 o 18 pr cn n pu-

ing ownwr prssur on cor inion this is onl pr-

ill os b iionl inionr prssurs ssoci

wih prciion o h Cnin ollr tol CPI inionclins b signicnl grr moun, sinc som com-

ponns r ircl c b lowr oil prics

26 APPENDIX: THE IMPACT OF LOWER OIL PRICES ON THE CANADIAN ECONOMYBaNk Of CaNada MONetaRy POLICy RePORt JaNUaRy 2015

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