Business and Economics Growth Related Questions

Output Gaps Closing in US and Canada

Author(s): Ray Barrell and Dawn Holland

Source: National Institute Economic Review , January 2004, No. 187 (January 2004), pp. 16-20

Published by: Cambridge University Press

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16 National Institute Economic Review No. 187 January 2004

Output Gaps Closing in US and Canada

United States

Output in the US rose by 2 per cent in the third quarter of 2003, driven by a 3.7 per cent rise in investment and a 1.7 per cent rise in consumer spending, while the weaker exchange rate also allowed net trade to make a small positive contribution to growth. The current account deficit stood at about 5 per cent of GDP last year, and it seems unlikely that the level of external borrowing required to finance domestic deficits can rise significantly or be sustained at current levels indefinitely. We would judge that the exceptional growth rate of the magnitude seen in the third quarter cannot be maintained under these conditions, and is best viewed as a one-off outlying observation. Nonetheless, growth in the US has been at or above potential for most of the past 2 years, and we are continuing to project further rises in output of about 0.9 per cent per quarter in 2004, allowing the US output gap to close by the middle of this year. We are projecting a rise in US output of nearly 3 per cent in 2003 and nearly 4 per cent in 2004, which is

roughly V4-V2 percentage point higher than we were expecting in October. These growth rates have been supported by low, and currently negative, real interest rates and significant tax cuts. A short term risk to our central scenario centres around the unusual outcome for

the third quarter of 2003, which may turn out to reflect a forward shift in expenditure that will be followed by one or several quarters of weak growth or even contraction to correct the overall level of output.

Recent revisions to the national accounts have not had a

dramatic impact on the historical growth path, and have not led to any notable revisions of our longer term forecast. We continue to expect growth of about 3 per cent in 2005, and about 23/4 per cent per annum in our medium term projections for 2006-2010. While demand side factors are key to our short-term forecast, in the medium to long term our projections for potential output are largely governed by estimates of participation rates

Table 5. United States percentage change

2000 2001 2002 2003 2004 2005 2006-2010

Consumption 4.7 2.5 3.4 3.1 3.4 2.4 2.1

Investment: housing 0.8 0.3 4.9 6.7 4.7 2.4 3.7 : business 8.7 -4.5 -7.2 1.7 2.8 6.0 7.3

Government: consumption 1.7 2.8 3.6 4.1 3.9 0.7 2.1 : investment 3.6 2.5 5.0 1.8 3.5 2.1 2.1

StockbuildingM -0.1 -0.9 0.4 -0.1 0.1 0.0 0.0 Total domestic demand 4.4 0.7 2.8 3.1 3.5 2.5 2.8

Export volumes 8.7 -5.2 -2.4 1.4 9.8 9.1 6.7

Import volumes 13.1 -2.6 3.3 3.7 5.2 3.3 5.5

GDP 3.7 0.5 2.2 2.9 3.9 3.1 2.8

Savings ratio 2.4 1.8 2.4 2.4 2.9 2.2 1.0

Average earnings 6.4 3.5 2.6 3.0 2.4 3.6 4.0

Private consumption deflator 2.5 2.0 1.4 1.8 2.1 2.2 2.2 RPDI 4.6 1.8 4.1 3.1 3.9 1.7 1.9

Unemployment, % 4.0 4.8 5.8 6.0 5.8 5.9 5.9

General Govt, balance as % of GDP General Govt, debt as % of GDP

1.5

58.0 -0.5

58.0 -3.4

59.8 -4.8

59.0 -5.9

62.0 -4.9

64.0 -3.5 65.4

Current account as % of GDP Net Overseas Assets as % of GDP

-4.2 -15.9

-3.9

-22.7 -4.6

-24.5 -5.0

-25.2 -5.2

-27.2 -4.6

-29.7 -4.4

-32.0

2000 2001 2002 2003 2004 2005 2006-2010

Consumption 4.7 2.5 3.4 3.1 3.4 2.4 2.1

Investment: housing 0.8 0.3 4.9 6.7 4.7 2.4 3.7 : business 8.7 -4.5 -7.2 1.7 2.8 6.0 7.3

Government: consumption 1.7 2.8 3.6 4.1 3.9 0.7 2.1 : investment 3.6 2.5 5.0 1.8 3.5 2.1 2.1

StockbuildingM -0.1 -0.9 0.4 -0.1 0.1 0.0 0.0 Total domestic demand 4.4 0.7 2.8 3.1 3.5 2.5 2.8

Export volumes 8.7 -5.2 -2.4 1.4 9.8 9.1 6.7

Import volumes 13.1 -2.6 3.3 3.7 5.2 3.3 5.5

GDP 3.7 0.5 2.2 2.9 3.9 3.1 2.8

Savings ratio 2.4 1.8 2.4 2.4 2.9 2.2 1.0

Average earnings 6.4 3.5 2.6 3.0 2.4 3.6 4.0

Private consumption deflator 2.5 2.0 1.4 1.8 2.1 2.2 2.2 RPDI 4.6 1.8 4.1 3.1 3.9 1.7 1.9

Unemployment, % 4.0 4.8 5.8 6.0 5.8 5.9 5.9

General Govt, balance as % of GDP General Govt, debt as % of GDP

1.5

58.0 -0.5

58.0 -3.4

59.8 -4.8

59.0 -5.9

62.0 -4.9

64.0 -3.5 65.4

Current account as % of GDP Net Overseas Assets as % of GDP

-4.2 -15.9

-3.9

-22.7 -4.6

-24.5 -5.0

-25.2 -5.2

-27.2 -4.6

-29.7 -4.4

-32.0

Note: (a) Change as a percentage of CUK

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The World Economy 17

and the equilibrium level of unemployment as well as by an estimated underlying production function describing the supply side of the economy1. As discussed in a previous National Institute Economic Review (Is the US facing a jobless recovery?, October 2003, pp. 16-17), there appears to have been a shift in labour productivity since 2001, reflecting changes in technology, and this is incorporated into our projections of output growth and the output gap.

Chart 6 plots two measures of the output gap for the US. The first is our standard measure, which is calculated using the approximate band pass filter technique described in Massmann, Mitchell and Weale (2003). This is dependent on our forecast assumptions about trend hours, equilibrium unemployment and the rate of technical progress. The second is the OECD's measure of capacity utilization in manufacturing, based on a survey conducted by the Census Bureau. Historically the two measures have moved very closely together, although the relationship seems to have broken down somewhat in recent years, with capacity utilization maintaining an unexpectedly high level throughout most of the 1990s and failing to show significant improvement in the most recent quarters despite GDP growth that we consider to be roughly at or above trend. This may partly reflect a growing divergence between manufacturing and other sectors of the economy, with industrial production in manufacturing registering a decline of 0.7 per cent in

2003. This could perhaps reflect the delayed effects of the overvaluation of the dollar through 2002, and it may be reversed in the forecast period.

Employment growth has remained disappointing, failing to keep pace with the strong recovery in GDP growth, and unemployment is relatively high given the level of capacity utilisation. The most recent indicators are slightly more promising, with total employment rising by 0.5 per cent in the fourth quarter and the unemployment rate dropping to 5.7 per cent in December from a recent high of 6.3 per cent in June 2003. But these aggregate figures mask the discouraging impact that weak employment prospects have had on labour force participation rates, which are at their lowest level since 1988. This may be a reflection of the apparent loss of bargaining power of employees over wage negotiations, which has impacted on real wages. With labour productivity growth in 2003 reaching its highest level since 1971, relatively modest growth in real wages of about 1 per cent indicates that firms rather than employees have so far reaped the benefits of the rise in productivity, allowing a sharp rise in the profit share of income, as illustrated in Chart 7. This may reflect a permanent recovery of the profit share, which dropped sharply between 1998 and 2000 from its historical level. Weak wage growth is also a reflection of public sector pay agreements, as states struggle to recover from a 6 per cent shortfall in revenue in the 2003 fiscal year.

Chart 6. Output Gap and Capacity Utilisation

output gap

(left scale)

capacity utilisation

(right scale)

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(N NO 00 o "*■ NO ON ON ON On o O O O ON ON ON On o O O O

— (N fS <N

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I 8 National Institute Economic Review No. 187 January 2004

Chart 7. Profit share of income

0.29

0.28

0.27

0.26

0.25

0.24

0.23

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0.29

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Assuming a small further rise in the profit share towards its historical average, wage and employment growth are likely to remain relatively weak in 2004 and 2005, and the unemployment rate is expected to hover just below 6 per cent for the next several years.

Producer price pressures are somewhat more subdued than anticipated, especially given the depreciation of the dollar. Our realignment simulations would suggest that the 6 per cent fall in the dollar against the euro that we have seen between November 2003 and January 2004 might add 0.2 percentage points to inflation in 2004. However, the persistent weakness in the manufacturing sector and a looser labour market than the headline unemployment rate would indicate suggest that inflationary pressures are, in fact, more subdued than anticipated. As a consequence we have revised our forecast for inflation in 2004 down by ¥t percentage points, to 2.1 per cent. We continue to expect an inflation differential relative to the Euro Area of roughly

Vi per cent per annum for the next several years, as the 13 per cent shift in the bilateral exchange rate since the start of 2003 gradually feeds into consumer prices. The realignment will eventually improve the US current account, although the J curve effect on relative prices should imply a deterioration worth 0.4 per cent of GDP in the first year before improvements set in. In the medium term we should see the 15 per cent fall in the dollar euro rate improving the US current balance, with the deficit projected to fall to 4Vi per cent of GDP. Low levels of US personal sector saving and higher levels of

government borrowing suggest that balance of payments current account deficits are likely to persist for many years.

The US fiscal deficit remains a burden to the medium term outlook for the US, although our budgetary projections for 2004, when the deficit is expected to reach nearly 6 per cent of GDP, is a modest improvement on projections made in October, due to the stronger outlook for growth and therefore revenue. The improvement to the deficit in 2005, worth nearly one per cent of GDP, continues to rely heavily on 'sunset clauses' in the Jobs and Growth package, which impart a temporary time horizon to tax cuts introduced in 2003 and 2004. It is likely that the 2005 Budget Proposal released in February will advocate extending some of these tax cuts on a permanent basis. As we discussed in the October Review, this can be expected to raise the general budget deficit ratio by approximately 1.4 percentage points in 2005 and 1 percentage point in our average medium term projections to 2010.

Canada

The outcome for Canadian GDP growth in the third quarter, at 0.3 per cent, was slightly weaker than expected in October, and our estimate for growth in 2003 as a whole has been revised down by 0.2 percentage points to 1.7 per cent. A series of negative shocks hit Canada in 2003: forest fires, massive power outages, SARS and BSE. Despite these, domestic demand remained resilient and we estimate rose by nearly 4 per cent in 2003 as a whole, but exports declined for the fourth consecutive quarter in the three months to September, largely due to the appreciation of the Canadian dollar and deteriorating terms of trade vis-à vis the US, Canada's primary trading partner. Canada's trade-weighted effective exchange rate has risen by nearly 20 per cent since the end of 2002. While the level in both nominal and real terms is below the average in the 1970s and 1980s, the Canadian dollar has not been this strong in over a decade (Chart 8).

Although the Canadian output gap continued to widen in the third quarter of last year, we are projecting a turn around in the final quarter of the year, with the output gap due to close by the end of next year. Available monthly figures for trade point to a strong recovery in export growth in the final quarter of 2003, and exports are expected to expand by about 8 per cent in 2004. Strengthening domestic demand growth in the US may help redress the deterioration of the trade balance, but

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The World Economy 19

Table 6. Canada percentage change

average

2000 2001 2002 2003 2004 2005 2006-2010

Consumption 4.0 2.6 3.4 3.8 3.7 3.1 2.7 Private sector investment 5.9 3.3 -0.3 4.1 6.1 3.6 2.5

Government expenditure 2.7 4.4 4.1 3.7 3.3 3.3 2.9

StockbuildingOO 0.1 -0.2 0.1 0.1 0.0 0.0 0.0 Total domestic demand 4.2 2.9 2.9 3.9 4.0 3.2 2.7

Export volumes 8.8 -3.1 -0.1 -1.7 8.1 5.5 5.5

Import volumes 8.0 -5.0 0.6 4.7 10.0 6.4 5.8

GDP 5.3 1.9 3.3 1.7 2.7 2.9 2.7

Private consumption deflator 2.2 1.8 1.9 1.8 I.I 1.2 1.7

Unemployment, % 6.8 7.2 7.6 7.7 7.4 7.3 7.4

Govt, balance as % of GDP 3.0 1.4 0.8 1.0 0.8 1.0 0.6 Govt, debt as % of GDP 80.0 81.7 76.0 72.9 70.9 68.6 60.8

Current account as % of GDP 2.9 2.4 2.0 2.2 2.1 1.3 1.3 Net Overseas Assets as % of GDP -18.2 -17.1 -15.5 -12.2 -13.9 -15.6 -16.9

average

2000 2001 2002 2003 2004 2005 2006-2010

Consumption 4.0 2.6 3.4 3.8 3.7 3.1 2.7 Private sector investment 5.9 3.3 -0.3 4.1 6.1 3.6 2.5

Government expenditure 2.7 4.4 4.1 3.7 3.3 3.3 2.9

StockbuildingOO 0.1 -0.2 0.1 0.1 0.0 0.0 0.0 Total domestic demand 4.2 2.9 2.9 3.9 4.0 3.2 2.7

Export volumes 8.8 -3.1 -0.1 -1.7 8.1 5.5 5.5

Import volumes 8.0 -5.0 0.6 4.7 10.0 6.4 5.8

GDP 5.3 1.9 3.3 1.7 2.7 2.9 2.7

Private consumption deflator 2.2 1.8 1.9 1.8 I.I 1.2 1.7

Unemployment, % 6.8 7.2 7.6 7.7 7.4 7.3 7.4

Govt, balance as % of GDP 3.0 1.4 0.8 1.0 0.8 1.0 0.6 Govt, debt as % of GDP 80.0 81.7 76.0 72.9 70.9 68.6 60.8

Current account as % of GDP 2.9 2.4 2.0 2.2 2.1 1.3 1.3 Net Overseas Assets as % of GDP -18.2 -17.1 -15.5 -12.2 -13.9 -15.6 -16.9

Note: (a) Change as a percentage of GDP.

net trade will continue to make a negative contribution to growth this year and next, as strong Canadian domestic demand growth and favorable price developments pull in imports. Consistent with the J curve effect discussed in the previous section, the Canadian current account balance recorded a small

improvement in 2003 despite the appreciation of the exchange rate, but we expect it to worsen by about 3A percentage points of GDP relative to its level in 2002 in the medium term. We expect the Canadian economy to expand by 23A per cent this year and nearly 3 per cent next year.

While unemployment rose over the course of 2003, reaching 8 per cent in September, strong improvements were recorded in the final quarter, with the unemployment rate falling to 7.4 per cent in December. Most new jobs have been full time positions in the private sector, and labour market developments remain relatively positive compared to those across the border, with employment rising by an estimated 2 per cent last year. We expect the unemployment rate to stabilize at current levels of just below 7V2 per cent.

The housing market in Canada remains strong, spurred by low interest rates, strong employment growth, rising disposable incomes and shortages in the rental housing market. Housing starts continued to strengthen in the final quarter of 2003, indicating that developments in

this sector remain positive, which should continue to add support to consumption and housing investment this year. Consumer expenditure is expected to rise by about 3% per cent this year, as in 2003, and private sector investment growth is projected to rise to about 6 per cent in 2004, from 4 per cent in 2003.

Chart 8. Canadian effective exchange rates 1994=100

140 T

130

120

J"' 100

AC nominal

'\r.i

real

ii ''Vi

I I I I I I I I I I I I I I I I I I I I I I 1 I I I I I I I I I I I I I o-"rcorNvoo"<roors NNNOOCOO^O^OO CFvO^O^O^O^O^O^O^O

140 T

130

120

J'* 100

nominal

'\r.»

real

ii ''Vi

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20 National Institute Economic Review No. 187 January 2004

As expected by financial markets, the Bank of Canada cut interest rates to 2.5 per cent in mid January, citing the recent rise in the exchange rate as the main drag on the economy. This is the third interest rate cut in Canada since July, and it should begin to boost output. Chart 10 plots the effects of a simulated cut in interest rates in Canada using our model, NiGEM. A one point cut sustained for two years would raise output by 0.25 per cent in the first year after the change, and would put upward pressure on inflation, raising it by 0.4 percentage points. Current price pressures in Canada remain subdued however, leaving room for more cuts, with inflation projected to fall to nearly 1 per cent this year from 1.8 per cent in 2003. Inflation should remain relatively subdued for several years, as the impact of the exchange rate rise gradual feeds through into consumer prices.

Canada remains the only G7 economy on track to have a budget surplus this fiscal year and reported an unexpectedly high surplus for the fiscal year ending March 2003. A number of factors contributed to the

higher surplus, including higher personal and corporate income taxes, higher sales tax collections and lower transfers to businesses than anticipated. The surplus this year may reflect weaker expenditure than anticipated; Statistics Canada estimate that the power blackout in Ontario in August is likely to shave 0.3 per cent off government expenditure, as government operations were scaled back during this period.

Chart 9. Canadian Output Gap

2.5% j 2.0%

1.5% ft

1.0%

0.5%

0.0% —|l I I I I ll I I 1/ I I

-0.5% --

-1.0% -

-1.5%

-2.0% -L O <N cr- o <J\ (j\

NO 00 § <N NO

on O* C7N O O O o On O o O O O —■ — — (N (N CM CN

Chart 10. Impacts of a I point cut in interest rates sustained for two years

2007 2008

■ Output (% difference from base) □ Inflation (percentage point difference from base)

2007 2008

■ Output (% difference from base) □ Inflation (percentage point difference from base)

2.5%

2.0%

1.5% +\

1.0% -fl

0.5%

0.0%

-0.5%

-1.0% -

-1.5% -

-2.0% - o <N ^r sO 00 o <N TT >o

Ov O o o O O O a* o 0s o O O O

— — — (N (N «N <N

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