Since last fall, oil prices have plunged 50 per cent and nervousness is running high about a slowing Canadian economy. Lower oil prices will unambiguously hurt growth and the latest data on GDP point in that direction. About one-quarter of Canada's exports and private investment (excluding housing) are tied to the energy sector that, itself, accounts for about 10 per cent of GDP. Weakness in the oil and gas sector could also spill over to the wider economy. In response, the Bank of Canada surprised markets on January 21 and cut its policy rate – which had been on hold at 1 per cent since September, 2010. The currency fell and interest rates eased. The loonie currently is near a 6-year low against the U.S. dollar. So is the economy in trouble?
In the IMF's annual report on Canada released last week, forecasts for growth have been marked down. A further downgrade is likely to come given that oil prices have fallen further since the forecasts were made. The oil shock has been noteworthy in terms of its nature, size and sharpness – perhaps, best resembling 1986's supply-driven price decline, when Canada was not a large oil exporter. So it is hard to know with high confidence just how deep the effects might be. What is clear is that the energy sector is on the front lines and will take a hit. Recent announcements from the oil industry confirm plans for layoffs and scaling back investment in the near term.
However, there are good reasons to think the drag on growth will be manageable. And, after years of a beneficial oil boom and strong currency, there is an opportunity for some welcome rebalancing of the Canadian economy. First, the U.S. economy – Canada's main trading partner and a net oil importer – is expanding at a robust pace. This provides an important offset from abroad for weaker growth domestically. Lower oil prices act like a tax cut for consumers that should, if anything, support U.S. growth (and recent U.S. consumption data seem to reflect this).
Second, policy-makers have room to manoeuvre. The Bank of Canada already used some of its policy space to cut interest rates to insure against the downside risks to inflation and growth. Lower interest rates should mitigate some of the impact on lower household incomes caused by lower oil prices. On the fiscal side, the federal government is likely to achieve its balanced budget target this year and can shift into neutral with respect to its policy stance. This means less fiscal drag on the economy and room to support growth in the future, although provinces will need to continue with their consolidation efforts given longer-term challenges to their public finances.
Lastly, a weaker Canadian dollar and lower energy bill will help Canada's manufacturing companies. The largest provinces – Ontario and Quebec –may see a turnaround after years of mediocre growth. Overall, lower oil prices may spur a welcome rebalancing from consumption and housing toward exports and investment, especially outside the energy sector.
From a broader perspective, lower oil prices present both a challenge and an opportunity for Canada's economy. Many sectors stand to benefit from strong partner growth, lower energy costs, policy support and a more competitive currency. But more lasting benefits will depend on addressing lagging productivity in Canada. Here, structural policies – highlighted in the IMF report – are needed to enhance productivity in key sectors and facilitate a smooth reallocation of resources. Today's sharply lower oil prices may provide the push that's needed for long-lasting change.
The authors are the International Monetary Fund's Canada team. Hamid Faruqee is the IMF's Mission Chief to Canada, Lusine Lusinyan is a Senior Economist and Andrea Pescatori is an Economist.