Prospects for Growth and Inflation
The global economy performed better than expected in the first half of 2004, and prospects remain positive as we look ahead. However, the recent sharp increase in oil prices is expected to dampen world economic growth. Assuming that oil prices average about US$50 per barrel next year and US$44 per barrel in 2006, as suggested by prices in futures markets, the Bank's base-case projection calls for U.S. economic growth to moderate from about 4 1/2 per cent in 2004 to about 3 3/4 per cent in 2005, before rising to around 4 per cent in 2006.The U.S.-dollar prices of non-energy commodities are expected to remain at a relatively high level over the next two years as a result of the global economic expansion, but they are likely to ease over time as new sources of supply are developed.
There are risks to the Bank's base-case projection for the global economy. For 2005, there are both upside and downside risks to growth in the United States and China. As we look further ahead, the main uncertainties relate to the resolution of global imbalances, notably the current account imbalances in the United States and Asia, and to the timing and extent of fiscal consolidation in many industrial countries.
For Canada, the base-case outlook is for continued, though more moderate, expansion of exports. Ongoing strong growth in final domestic demand is expected to help support a solid economic expansion through 2006. Business investment is projected to strengthen further, and gains in real incomes should support consumer spending. Housing investment is expected to stabilize at current high levels. Import growth is likely to pick up, reflecting strong domestic demand and the continued adjustment to the appreciation of the Canadian dollar. However, given the various forces at play in the global economy, there are risks around our projections for imports and exports, and for business investment.
The aggregate impact of higher oil prices on the Canadian economy is expected to be slightly positive over the medium term, since the associated reduction in manufacturing exports and consumer spending should be offset by increased output and capital investment by energy-producing firms. But given the time necessary for regulatory approval in many cases, and the potential for shortages of materials and labour, the positive impact of higher oil prices on energy-producing firms is likely to be limited in the short term. Thus, the Bank projects that high oil prices will be a small net drag on the economy in 2005.
Overall, the Bank expects the Canadian economy to grow, on average, at the 3 per cent annual growth rate of potential through to the end of 2006. Given the effects of higher oil prices and the past appreciation of the Canadian dollar, the Bank projects growth to be slightly less than 3 per cent in 2005 and slightly more than 3 per cent in 2006. This base-case scenario assumes further reduction of monetary stimulus over time to keep the economy near its production potential and achieve the inflation target.
With the economy operating near potential over the projection period, we expect core inflation to move up from about 1 1/2 per cent in the fourth quarter of 2004 to the 2 per cent target by the end of 2005 and to stay there through 2006. The past appreciation of the Canadian dollar is expected to continue to exert slight downward pressure on core inflation through 2005.
Movements in crude oil prices will continue to dominate the outlook for total CPI inflation. Based on the assumption that prices will follow the path currently embedded in oil futures, the Bank projects that total inflation will rise to the top of the 1 to 3 per cent target range in the first half of 2005, before falling slightly below core inflation in early 2006.
This is a summary of the Monetary Policy Report of the Governing Council of the Bank of Canada.
The Report is based on information received up to the fixed announcement date on 19 October 2004.
