Canadian and U.S. economies are converging but danger lurks: Don Pittis

On the face of it, Bank of Canada governor Stephen Poloz and his deputy Carolyn Wilkins had some excellent news about the Canadian economy in yesterday's Monetary Policy Report.

The happy story included falling mortgagerates, continued employment strength and growing business investment that have pushed Canadian economic growth rates higher in the first half of the year than almost anyone expected.

But as global trade threats linger, Canada's top central bankers warn that many people who should know better, including stock market investors, seem to think cuts to interest rates can solve all problems.

In a complex world riven by trade disputes, they say, there are simply limits to the power of central bankers to patch things up. The warnings, including hints of the possibility of a new bout of stagflation, were effectively a message that rate cuts are no easy answer for the damaging effect ofa global trade war.

'Significantly negative scenario'

"The underlying shock would be very bad for economic growth, it would be bad for the levelof productivity, it would be quite harmful to profitability," said Polozof a potential growing trade spat."It would be a pretty significantly negative scenario."

More on that later, but first a look at why the Canadian central bank foresaw Canada's interest rates remaining steady while on thesame day U.S. central banker Jerome Powell implied in congressional testimony that U.S. interest rates were about to fall.

While that sounds likethe U.S. and Canada diverging, the senior deputy governor of Canada's central banksaid at yesterday's news conference, instead it was a sign that the two economieswere growing together.

"In fact, it's a sign of convergence, and this is because the two countries are at different points in our economic cycles," said Wilkins. "The U.S. is slowing to a more sustainable pace while Canada is moving back up to its trend growth."

At the end of last year there were signs businesses were shying away from new Canadian investments due to fears a new NAFTA would not be resolved. Even as that fear faded, the U.S. steel and aluminum tariffs and U.S. President DonaldTrump's threats against Mexico over immigration left a lingering feeling of caution.

Wilkinssaidresolving all those difficultiesplus renewed strength in the Canadian oil and gas sector have helped to stimulate business investment confidence.

Signs of a return to confidence in the Canadian housing market, including five-year mortgage rates returning to levels of five years ago, mean real estate will once again be a growth stimulant rather than a drag.

Of course, as Poloz remarked, Canadian business still has an interest rate advantage.U.S. interest ratesat 2.5 per cent are well above Canada's 1.75 per cent.

Futures markets foresee Canada holding interest rates steady this year while the Fed makes three quarter-point cuts. Barring other potential shocks, that would put the two rates back into sync.

Jobs complexity

While business confidence and a partial return to strength in oil andhousing markets are clear drivers, the central bankers saycontinued strength in new hiring is slightly more mysterious.

Wilkins says economists have had trouble working out a clear relationship between the timing of GDP growth and waves of new hiring, just one of the complexities that make looking into the economy's future a far-from-exact science.

Despite resolution of many of the trade worries the bank has described in the past, Poloz and Wilkins say they and their advisers still believe the biggest risk for Canada's economic future remains trade. The bank's strategy for trying to address something it cannot control is to draw up two divergent scenarios.

For those interested, the two extreme outlooks are described in Box 2 on Page 21 of the Monetary Policy Report. And of course the gloomierone, an all-out trade war, is the moreinteresting.

In describing this bleaker scenario Polozforesees that central banks, with their single superpower of making money cheap, simply may not be equipped to deal with the repercussions. And he says it is here that stock market investors, blithely assuming lower rates will always make stocks go higher, may be mistaken.

"The markets are not really onto the complexity of it," said Poloz, describing an event where trade barriers raised the cost of imports while a falling loonie added to the effect.

"In that moment you have a trade-off between a slowing economy and rising unemployment and rising inflation at the same time," said Poloz. "And obviously monetary policy would not be able to buffer both of those."

All the more reason for Canadians to hope the Bank of Canada's good news scenario where "the global economy broadly returns to pre-2017 trade arrangements, and uncertainty about future trade policy dissipates" is the one that comes true.

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