Growth and labour input in North America.

Output growth slowed in the US and Mexico in the first quarter of 2007, while the Canadian economy accelerated. The US and Mexico both suffered from weak export growth, with the housing market continuing to put strain on domestic demand growth in the US. In aggregate, North American growth slowed

to just 0.3 per cent relative to the previous quarter. Inflation accelerated in both the US and Canada in the first half of 2007, prompting a rise in Canadian interest rates. Rising inflation stems partly from tight labour markets, which have put upward pressure on wages. Labour market pressures in Canada are likely to be offset by the impact of the 6 per cent rise in the country's effective exchange rate between the first and second quarters of 2007, whilst the renewed weakness of the dollar, which fell by 2 per cent in effective terms between the first and second quarters of 2007, is likely to exacerbate inflationary pressures.

Over the period 2001-5, GDP growth in both the US and Canada averaged about 2 1/2 per cent per annum. However, as illustrated in table 2 of the previous section, this masks large discrepancies between the contributions of labour productivity and labour input in the two economies.

[FIGURE 6 OMITTED]

Labour productivity growth in the US averaged 2 per cent per annum, while it averaged just 1 per cent per annum in Canada.

Weak productivity growth in Canada was offset by an average annual rise of 1.5 per cent in labour input, while in the US labour input rose by just 0.3 per cent per annum. Labour input can be further decomposed into demographic developments, shifts in labour force participation rates, average hours worked and shifts in the employment rate. The working age population rose at an average annual rate of 1.3 per cent in Canada and 1.1 per cent in the US, so demographic developments can account for only a small share of the discrepancy in labour input growth. Both countries also recorded similar rates of decline in average hours worked. The key sources of the differences in labour input growth stem from developments in the employment rates and in the labour force participation rates.

Labour force participation rates in Canada rose at an average annual rate of 0.4 percentage points from 2001-5, while they declined by 0.2 percentage points per annum in the US. This widened the large gap between Canadian participation rates, which are already high by international standards at about 80 per cent of the working age population, and relatively low US participation rates of about 65 per cent. It is difficult to see much scope for further rises in participation sustaining growth in Canada over the coming years, although there remains ample room for a rise in US participation rates.

Changes in the employment rate and the participation rate are closely linked, and it is not surprising that we have seen a rising employment rate in Canada and a declining rate in the US. The Canadian employment rate rose by 0.4 percentage points per annum on average during 2001-5, while the US employment rate declined by 0.3 percentage points per annum. This also partly reflects the differences in productivity growth, as Canadians have sacrificed productivity for higher employment, while the opposite is true for the US. Figures 7 and 8 show that the unemployment rate in the US has been slightly high relative to developments in the output gap, whereas in Canada the unemployment rate has been low relative to developments in the output gap. This points to a structural shift in labour market behaviour especially in Canada, with Canada seeming able to sustain a lower rate of unemployment.

[FIGURES 7-8 OMITTED]

United States

We are projecting a significant slowdown in the US economy this year, with output expected to rise by just 2.1 per cent. While the housing market continues to weigh on the economy, the marked downward revision to our forecast compared to three months ago stems from the outturn for export growth in the first quarter of 2007, which was significantly weaker than expected, recording a rise of just 0.2 per cent relative to the previous quarter. Exports of industrial supplies and capital goods declined relative to the previous quarter, while food and beverage exports recorded only weak growth. Seasonally unadjusted data suggest that much of the lost trade was contained within NAFTA, with some loss of exports to East Asia as well. We expect a recovery in export volumes over the course of the year, and forecast export growth of 6-6 1/4 per cent per annum this year and next.

There was a further drop in US housing investment in the first quarter of 2007, and we forecast a decline of 12 1/2 per cent for the year as a whole. House price growth, according to the Office of Federal Housing Enterprise Oversight, slowed to 0.5 per cent on a quarter-on-quarter basis, and prices are forecast to stagnate over the next several quarters. Despite the weak housing market, consumer spending remained strong in the first quarter of the year, rising at an annualised rate of 4.1 per cent. However, monthly data for April and May indicate that there has been a marked slowdown in household spending, with annualised growth of about 1.4 per cent anticipated. We expect this weakness to persist into mid-2008, and forecast annual consumer spending growth of 3 per cent this year and 2 per cent next year. The impact of the slowdown in nominal housing wealth growth is exacerbated by high inflation. This will also impact on the rate of growth of real disposable income, which we expect to grow by only 1.5 per cent in 2008. In both 2007 and 2008 we anticipate that consumers will smooth their real consumption path, and consumption growth will be more rapid than real income growth. As a result the personal sector savings rate, which is already negative, will fall further.

The recent decline in the personal sector saving rate can be partly attributed to rising energy prices, while it has also been held down by the rise in household receipts from corporations in the form of share repurchases (see Steindel, 2007). Unlike dividend payments, these are not included in the calculation of income, although some portion is used to finance consumption. The danger of a low saving rate is that the accumulation of capital may be suboptimal and reduce longer-term income growth prospects. However, investment is determined by national saving flows, and it would be misleading to put too much emphasis on the personal sector saving rate. The gross national saving rate in the US has also fallen to unusually low levels in recent years, but it did recover to some extent in 2006, while the personal sector saving rate deteriorated further. Capital gains mean that household wealth has risen since 2004 despite low household saving. However, as the collapse of housing investment and stagnating house prices feeds into housing wealth, wealth accumulation in the personal sector is expected to slow over the forecast horizon.

Annual core inflation in the US has been above 2 per cent for three years, and exceeded total inflation for the past two quarters, standing at 2.3 per cent in the first quarter of 2007. This has kept the Federal Reserve on alert, and interest rate cuts in 2008 that had been priced into the yield curve three months ago are no longer anticipated. Monthly figures suggest inflation measured by the total consumer expenditure deflator remained at a similar rate in the second quarter, and we forecast inflation of 2 1/2-2 3/4 per cent this year and next. Inflationary pressures have come from several directions. Oil and gasoline prices have continued to rise, wage growth has responded to the low unemployment rate, with a rise of 4.8 per cent in 2006, and the recent drop in the dollar will add inflationary pressure in the second half of the year. However, capacity pressures will ease over the course of the year, as the positive output gap is eliminated.

The US fiscal position has improved markedly since 2004, with the deficit narrowing from 4.6 per cent of GDP to just 2.3 per cent in 2006. The government's target to halve the federal deficit by 2008 has been achieved earlier than expected. The improvement in the deficit was largely due to an unexpected boom in both corporate and income tax receipts, rather than any discretionary policies implemented by the government. The government has put forward a new target to eliminate the federal deficit by 2012. The discretionary policies proposed do not include significant tightening measures to achieve this target, which seems to rely on further windfall tax gains. In any case, the current administration will not remain in power to see this target through, and our forecast is based on a neutral policy. We forecast a slight deterioration of the general deficit to about 2 1/2 per cent of GDP over the medium term, which assumes tax receipts will grow more closely in line with income than they have in recent years.

The US current account balance averaged 6.1 per cent of GDP in 2006, and we anticipate a current account balance of 6-6 1/4 per cent on average over our forecast horizon. Since 1997, the current account balance has fallen by 4 per cent of GDP, raising fears over the sustainability of a deficit of this size. One factor that has allowed the deficit to be sustained at this level for over two years is the unexpectedly strong position of net foreign assets. The net stock of foreign assets shows the aggregate indebtedness of the US to the rest of the world. The current account flows onto the stock of net assets, as any deficit must be financed through the sale of domestic assets to foreigners or the selling off of foreign assets held abroad. The identity relationship between the current account and the stock of foreign assets can be described by the following set of equations:

GA = [GA.sub.-1] *[reval.sub.GA]+ [FLOW.sub.GA] (1)

GA = [GA.sub.-1] *[reval.sub.GL]+ [FLOW.sub.GL] (2)

[FLOW.sub.GA] - [FLOW.sub.GL] = CBV (3)

where GA is the stock of foreign assets, GL is the stock of foreign liabilities, [reval.sub.GA] and [reval.sub.GL] are revaluation terms, which adjust the previous quarter's stock by developments in exchange rates, equity prices, and bond prices, [FLOW.sub.GA] and [FLOW.sub.GL] are the current accumulation of new foreign assets and liabilities, respectively, and CB V is the current account balance. The equations that we use to model foreign assets on our model NiGEM distinguish between assets held in equities and foreign direct investment, bonds, and banking sector assets, and the revaluation term applied depends on the type of asset. Our model equations make it clear that the net foreign asset position has remained stable thanks to the revaluation effects. In fact, a model-based backcast from 1997 suggests that the net foreign asset ratio could be even higher than it stands currently, given the high share of assets held in equities and foreign direct investment and exchange rate developments, which have adversely affected the value of assets held in US dollars and benefited assets held in other currencies. Figure 9 illustrates the actual stock of net foreign assets as a per cent of GDP compared to our model-based backcast from 1997. This relatively strong net foreign asset position suggests that the US current account deficit can be sustained at current levels for the time being without the stock of net assets falling to minus 100 per cent of GDP.

[FIGURE 9 OMITTED]

Canada

The Canadian economy performed well in the opening months of this year with output increasing by 0.9 per cent in the first quarter of 2007, shrugging off sluggish growth in the last three quarters of 2006. Domestic demand growth remained solid, growing at 1.0 per cent in the first quarter of 2007 compared with a decline of 0.1 per cent in the previous quarter. The main driving force behind this strong growth in domestic demand is due to healthy consumer spending and a rebound in residential investment after three consecutive quarterly declines. As we discussed in Holland (2007), there appears little risk of Canada facing a housing market downturn of the magnitude seen in the US. Over the medium term, we see Canadian GDP moving closely in line with that of the US, but this relies on an acceleration of labour productivity growth, which has lagged the US in recent years.

In the first quarter of 2007, the trade sector had a negative impact on Canadian GDP growth overall, as booming consumption helped keep import volumes high, while a further strengthening of the Canadian dollar and rising oil prices restrained export growth. We expect however to see some rebound in the volume of Canadian exports this year, after the weak performance of the previous two years. Export volumes increased by only 0.7 per cent in 2006, following a rise of just 2.2 per cent in 2005. We expect export growth to strengthen this year and in 2008 which will allow the current account balance to remain positive throughout the forecast horizon. With Canadian average job creation of just above 34,500 per month in the first half of this year, the rate of unemployment remained at 6.1 per cent in June for the fifth consecutive month, a 32-year low. Seasonally adjusted core inflation, as measured by the annual percentage changes in the core Consumer Price Index, climbed to 2.5 per cent in June, with overall inflation forecast to be 2.1 per cent for this year. However, as excess domestic demand lessens throughout the forecast horizon, inflation should decline to 1 3/4 per cent in 2008 and remain at this level in the medium term. Since our last forecast in April, the Bank of Canada has taken further action to offset the onset of higher inflation and greater excess demand. There has been an increase of 25 basis points in the target for the overnight rate, taking the rate to 4 1/2 per cent per annum and marking the first interest rate move since May 2006. In line with market expectation, we anticipate short-term interest rates increasing by a further 25 basis points by early 2008.

In the short and medium term, we expect the fiscal stance to remain unchanged since April, characterised by moderate increases in government consumption. The budget surplus is expected to shrink from 1.0 per cent of GDP this year to a near balanced budget in the medium term.

Table 6. United States
Percentage change

                                2003     2004     2005     2006

Consumption                     2.8      3.9      3.5      3.2
Investment : housing            8.4      9.9      8.6     -4.2
             business           1.0      5.9      6.8      7.2
Government : consumption        2.5      2.1      0.9      1.6
             investment         2.2      0.6      1.1      4.0
Stockbuilding (a)               0.0      0.4     -0.3      0.2
Total domestic demand           2.8      4.4      3.3      3.2

Export volumes                  1.3      9.2      6.8      8.9
Import volumes                  4.1     10.8      6.1      5.8

GDP                             2.5      3.9      3.2      3.3

Average earnings                4.6      4.0      4.0      4.8
Private consumption deflator    2.0      2.6      2.9      2.7
RPDI                            2.5      3.7      0.9      2.5
Unemployment, %                 6.0      5.5      5.1      4.6

General Govt. balance          -4.8     -4.6     -3.7     -2.3
as % of GDP
General Govt. debt             59.5     60.5     60.8     60.6
as % of GDP

Current account as % of GDP    -4.8     -5.5     -6.1     -6.1

                                                 Average
                                2007     2008    2009-2013

Consumption                     3.0      2.0      2.6
Investment : housing          -12.6      1.3      2.5
             business           2.7      3.6      2.8
Government : consumption        2.0      2.4      2.5
             investment         2.7      2.9      2.6
Stockbuilding (a)              -0.1      0.1      0.0
Total domestic demand           1.9      2.3      2.6

Export volumes                  6.3      6.1      4.1
Import volumes                  3.2      3.2      4.0

GDP                             2.1      2.6      2.6

Average earnings                3.9      4.3      4.1
Private consumption deflator    2.5      2.7      2.3
RPDI                            2.4      1.5      2.6
Unemployment, %                 4.6      4.6      4.9

General Govt. balance          -2.1     -2.0     -2.6
as % of GDP
General Govt. debt             60.3     59.1     58.4
as % of GDP

Current account as % of GDP    -6.3     -6.0     -6.2

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

Table 7. Canada Percentage change

                                2003     2004     2005     2006

Consumption                     3.0      3.4      3.8      4.2
Private sector investment       6.4      8.1      8.4      7.2
Government expenditure          3.4      2.8      3.2      3.9
Total domestic demand           4.5      4.3      5.0      4.4

Export volumes                 -2.3      4.8      2.2      0.7
Import volumes                  4.1      8.3      7.5      5.0

GDP                             1.9      3.1      3.1      2.8

Private consumption deflator    1.6      1.5      1.7      1.4
Unemployment, %                 7.6      7.2      6.8      6.3

Govt. balance as % of GDP      -0.1     0.8       1.6      1.0
Govt. debt as % of GDP         75.5     70.5     68.4     67.5

Current account as % of GDP     1.2      2.3      2.0      1.6

                                                 Average
                                2007     2008    2009-2013

Consumption                     4.0      2.8      3.0
Private sector investment       3.7      3.8      2.2
Government expenditure          2.5      2.9      3.1
Total domestic demand           3.1      3.0      2.8

Export volumes                  4.6      3.9      3.3
Import volumes                  5.3      4.5      3.6

GDP                             2.8      2.8      2.6

Private consumption deflator    2.1      1.8      1.7
Unemployment, %                 6.0      6.1      6.5

Govt. balance as % of GDP       1.0      1.0      0.2
Govt. debt as % of GDP         62.8     60.4     54.2

Current account as % of GDP     2.5      2.0      1.5