4. What is your economic outlook for North America in 2006?
Growth rate disparities between Canada, the U.S. and other G7 economies are in the process of narrowing. Just as Canadian real GDP growth is accelerating, the U.S. economy is set to slow moderately. We expect real Canadian GDP growth to pick up from 2.9 per cent in 2005 to 3.4 per cent in 2006 and U.S. real GDP growth to slow from 3.4 per cent in 2005 to 3.2 per cent in 2006. Lower inflation, a more accommodative monetary policy, and sharply higher energy and non-energy commodity prices are behind the expected improvement in Canadian growth. The U.S. economy is expected to slow down because consumers and businesses are expected to begin saving more in response to higher interest rates.
Lower U.S. investment and consumption growth should lead to less borrowing of foreign funds. As a result more funds are expected to remain in lending countries promoting local investment and consumption. We expect improving Canadian growth in 2006 to result in continued rate hikes and the Bank of Canada overnight rate of interest is expected to reach 4 per cent by April 2006. The U.S. federal funds rate has already been rising for over a year and is expected to peak at 4.25 per cent in the last quarter of 2005 and remain at that level in 2006. The rising cost of raw material inputs along with rising wages pushed the U.S. Federal Reserve to act earlier than the Bank of Canada in hiking rates.
Longer-term interest rates are also expected to rise in both countries alongside slowly mounting core consumer price index inflation pressures, leading mortgage rates to rise. The hot Canadian and U.S. housing markets are expected to soften as demand shifts lower with higher borrowing costs. Unlike prior real estate cycles, however, an implosion of the real estate market in either country is unlikely since construction has only kept pace with demand as speculative construction frenzy in both countries was avoided.
Given our outlook, several offsetting factors should keep the value of the U.S. dollar trading in a narrow range.
Firstly, less borrowing of foreign funds by the U.S. is expected to limit further weakening of the U.S. dollar. At the same time, however, the U.S. dollar could come under downward pressure with expectations of continued interest rate hikes in Canada and other G7 countries offsetting hikes in U.S. shortterm interest rates. Furthermore, the Canada-U.S. exchange rate will also be affected by weaker commodity prices. The Canadian dollar is, therefore, expected to fluctuate in a range of 82 to 85 U.S. cents. Other currencies are also expected to stabilize relative to the U.S. dollar in 2006 giving exporters in these countries a reprieve as they continue to adjust to intense pressure from Chinese exports.
The risks surrounding our North American economic outlook are unusually widespread. The war in Iraq and the threat of civil war if the U.S. pulls out early, increasing friction between China and Japan, not to mention the nuclear proliferation threat coming from North Korea could all lead to another bout of higher oil prices, lower demand, lower interest rates, rising inflation and perhaps a period of stagflation. For now, however, our base case consists of a converging business cycle between G7 economies, particularly between Canada and the U.S.