Focus
June 07, 2024 | 13:30
U.S.-Canada Matters: Three Key Themes
U.S.-Canada Matters: Three Key Themes |
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In the lead-up to this year’s U.S. elections, there are three dominant and disparate topics in the Canada-U.S. relationship that bear watching: trade, immigration, and a growth/inflation divergence. 1) Industrial and Trade Policy: Trade in a Time of ChaosWith the U.S. election fast approaching, no area of economic policy has received more attention than trade and industrial policies. Both political parties have moved toward a more protectionist stance in the past decade, with subsidies and tax incentives seeing strong take-up. For example, the Congressional Budget Office (CBO) recently estimated the energy components of the 2022 Inflation Reduction Act could cost US$800 billion over ten years, over twice the initial estimate of $391 billion. Both parties have also placed import tariffs on legacy industries facing competition with China. Most recently, President Biden imposed or raised tariffs on approximately $18 billion worth of annual imports from China. He also maintained President Trump’s earlier tariffs on over $300 billion worth of Chinese goods. Donald Trump has said that, if re-elected, he would add further restrictions to Chinese products and investment. And, he would subject all imports, regardless of origin, to an additional 10% tariff and impose a new tariff of 60% or more on all imports from China. |
On net, higher tariffs are expected to weigh on U.S. GDP growth, as the hit to real income and spending from higher prices outweighs the improved trade deficit and tax revenue, especially if other countries retaliate. Indirect impacts could include a sharp deterioration in financial conditions and business and consumer sentiment, along with more uncertainty in trade policy. Tariffs can effectively be a regressive tax on domestic consumption, i.e., the burden is largely borne by lower-income households as a higher share of their income goes to spending. According to the Peterson Institute for International Economics, Trump’s proposed new tariffs would cost U.S. consumers at least 1.8% of GDP before accounting for retaliation and lost competitiveness—nearly five times larger than the cost of the 2018-2019 U.S.-China trade war (Table 1). |
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These measures could also counter the Fed by temporarily raising broader inflationary pressures. Studies from the 2018-19 episode show the impacts fell almost entirely on the U.S. consumer and provided cover for domestic producers to also raise prices. Still, the overall inflation impact should be relatively modest, with each 1 ppt increase in the effective tariff rate expected to lift U.S. core consumer prices by around 0.1 ppt. Given Canada’s reliance on U.S. trade, some of this may flow through to Canadian CPI. As of 2023, Canada was the United States’ second-largest trading partner, moving back above China, but below Mexico (Chart 1). Canada was the top destination of U.S. exports (about 17% of the total) and third-largest source of U.S. imports, behind China and Mexico. Canada’s share of U.S. imports has trended down from around 20% in the mid-1990s to just above 13% now. |
However, one potential concern is the widening U.S. bilateral trade deficits with both Canada and Mexico (Table 2). While not nearly as lopsided as U.S. trade with China, the recent imbalances with these two trading partners could become a political flashpoint for the next U.S. Administration. So far, U.S.-Canada bilateral trade has largely side-stepped the worst of this protectionist pivot, somewhat shielded by the 2020 USMCA. Even so, the Trump Administration raised tariffs on steel and aluminum from Canada, along with most countries, from mid-2018 to May 2019, when the tariffs on Canada were lifted as part of the USMCA negotiations. The USMCA is due for review in 2026, potentially pulling Canada and Mexico directly into the crossfire. For Canada, the wider trade imbalance has been driven by the back-up in energy prices and some increase in oil volumes. Still, the combined share of the U.S. trade deficit from Mexico and Canada has pushed above 20%, comparable to the EU and not far below that of China. Moreover, we note two things: 1) Some of China’s exports to the U.S. are likely being re-routed to avoid tariffs, understating the bilateral U.S.-China imbalance, while potentially overstating Mexico’s imbalance; and 2) the ratio of U.S. exports to imports is still much healthier with Canada (85.0% in the past 12 months), and with Mexico (67.2%), than with China (34.2%). In other words, there really is no equivalent comparison between the overall imbalance in trade flows with the rest of North America and that with China. |
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Finally, Canada (and Mexico) could face additional challenges on trade policies aside from USMCA renewal. For instance, if Canada is compelled to move in lock-step with the U.S. on tariffs on Chinese EVs and other products, it could spark bilateral trade pressure from China. This could hit Canada harder given China’s importance as a destination for Canadian agricultural and forest products. 2) Immigration: Large ShiftsThe U.S. has seen a large influx of immigrants since the pandemic reopening. The CBO estimates that 3.3 million net immigrants arrived in the U.S. in 2023 (or roughly 1% of the resident population) compared with around 1.0 million a year prior to the pandemic. The CBO estimates that strong migration will continue at least over the next two years before moderating back toward pre-pandemic levels. At the same time, net immigration in Canada has reached record highs, with population growth at its highest pace since the late 1950s (3.2% y/y as of the start of 2024). New immigrants skew younger, bolstering the prime age working population at a time when the domestic population is aging. The Canadian government’s recently announced caps on international students and non-permanent residents (details of which will be announced later this year) are expected to bring Canada’s population growth down to a more manageable 1% y/y pace starting in 2025. In the near term, the immigration surge has added to demand for housing, transportation, food, health care, and other services. At the margin, this likely contributed to elevated price pressures, especially when housing markets were particularly tight. |
Yet, many of these new immigrants have bolstered labour supply and employment metrics over the last two years. In the U.S., the BLS estimates the labour force participation rate for immigrants in 2022 was around 50%. According to Statistics Canada, the participation rate for immigrants (landed within five years) is above 70%—that’s higher than the overall rate of just over 65%, likely reflecting the younger demographic of recent arrivals. In both countries, higher immigration means that employment growth doesn’t need to slow as sharply to bring the labour market into better balance. For instance, the Brookings Institution estimates the U.S. labour market can now accommodate monthly employment growth of roughly 160k-to-220k without adding to wage and price inflation pressures. This was especially evident in last year’s stellar job and real GDP growth performances even as consumer inflation rates cooled. However, the upcoming U.S. election raises uncertainty over immigration policies and, thus, the estimates of potential non-inflationary job growth. Canada’s recent population surge has been nothing short of dramatic. Even smoothed over a five-year period, population has risen at a 1.8% annualized rate, the fastest such pace in over 50 years. Temporary foreign workers are the top factor, but the surge is also driven by international students and refugees, who may not necessarily join the workforce. As well, the peak of the Baby Boom is reaching retirement age, so Canadian labour force growth is not nearly as steep as total population. Still, Canada’s labour force has grown at roughly twice the pace of the U.S. workforce over both the past 5 and 25 years (Chart 2). |
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Notably, the wide gulf in Canada-U.S. population and labour force growth has not translated into faster economic growth for Canada. A much weaker productivity performance has resulted in Canada lagging behind the U.S. in real GDP growth over the past five years (Chart 3). Even over the longer term, both countries have posted nearly identical GDP growth rates over the past 25 years (2.1% for Canada, 2.2% in the U.S.), even though Canada’s labour force has expanded almost twice as quickly on average over that period (1.4% versus 0.8%). |
3) Growth Divergence: This, Too, Shall PassCanada’s growth underperformance relative to the U.S. has deepened in the past year. Looking through the quarterly wobbles, real GDP in Canada is up by less than 1% in the past four quarters (to 2024 Q1) versus nearly 3% U.S. growth over the same period. The gap is primarily driven by the greater sensitivity of Canadian consumers to higher interest rates than their U.S. counterparts, due to a higher concentration of short-term fixed-rate mortgages and larger debt loads (Chart 4). Canada’s mortgage market is largely comprised of variable-rate and shorter-term fixed rate mortgages, typically five years or less (versus the availability of 30-year fixed-rate mortgages in the U.S.). Normally, this difference in mortgage terms doesn’t have a large bearing on growth differentials—but these are not normal times, given the extraordinary rate hikes in 2022/23. We’ll note that amid all the clamouring for the option of much longer-term mortgages in Canada, U.S. 30-year mortgage rates are now hovering around 7%, far above the five-year rates on offer in Canada of closer to 5%. |
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Despite the negativity swirling around Canada’s growth performance, we believe that there are grounds for optimism over the medium term. Strong population growth and earlier rate cuts drive of our forecast for a notable rebound in Canada’s real GDP growth in 2025—back to around 2%. The relatively weak growth of 2023/24 has allowed inflation to cool more rapidly, bringing it within sight of the 2% target. Another reason for guarded optimism for Canada is the fiscal backdrop. While far from pristine, Canada’s fiscal fundamentals are less concerning than those of the U.S. and many European economies. The IMF estimates Canada’s general government budget deficit at just over 1% of GDP this year, well below that in Europe (2.9%) and the U.S. (6.5%). The IMF estimate for Canada may be too lenient, as this budget cycle points to a combined federal & provincial deficit of just over 2% of GDP, still on the low end of major economies. This acts as a non-negative for Canada, as others face serious fiscal restraint in coming years. For longer-term consideration, the IMF estimates that Canada’s general government gross debt will rise to nearly 105% of GDP in the coming year, well below the U.S. (over 120%), but in line with the U.K. and above Germany. Altogether, the Canada-U.S. gaps in growth and inflation will lead to short-term divergence in monetary policy and additional softness in the Canadian dollar. This could aggravate the U.S.-Canada trade imbalance—amid sluggish Canadian spending (and imports) and an even more competitive exchange rate. However, we suspect that the U.S.-Canada growth gap will soon narrow; the sensitivity of Canadian consumers to interest rates will turn from a drag to a lift as borrowing costs recede. With thanks for the assistance of Shelly Kaushik. [A more detailed special report is also available here.] |