Boost the Canadian economy now: The productivity revolution we need

The Canadian economy needs a productivity revolution. Better economic times are hopefully coming for Canada after this year, but just how much better will depend on whether the country can turn the corner on its disappointing record for productivity growth.

Currently, we’re in the final stretches of a lacklustre period of productivity growth dating back to mid-2022. While real gross domestic product (GDP) has advanced, output per capita has been falling, and the unemployment rate has escalated, reflecting the drag from the higher interest rates that were necessary to quell inflation.

The good news for Canada is that inflation, if you strip out mortgage interest costs, is already running near 1.8%, as of June 2024. And that’s a key reason why the Bank of Canada (BoC) felt comfortable starting the process of bringing interest rates down. It can reasonably expect that as mortgage interest costs decelerate, the overall headline inflation number will also return to the 2% target.

By the end of 2025, the BoC’s overnight rate target should reach 2.5%, providing a lift to the pace of quarterly growth next year. That, and slowing immigration that reduces growth in the supply of labour, should enable the unemployment rate to decline again in 2025.

But over the medium term, our standard of living just doesn’t depend on getting people back to work, but on their output per hour. Productivity is the key to growing the economic pie, particularly on a per capita basis.

Our productivity has been extremely poor in the last year and a half or so, seeing outright declines. But some of that is because of economic softness, and we should be able to reverse those losses as businesses see brisker demand. Still, we’ve been trailing the U.S. in productivity growth over the prior decades. We need to see more business capital spending, and we need to see Canada play a bigger role in some of the innovative industries where you get the largest productivity gains. In other words, we need more of a revolution in terms of what we do in the Canadian economy, the skill sets workers have, and what incentives there are for business investment.

For investors, the prospect of lower interest rates is a direct plus for fixed-income assets. Bonds are now positioned to play their typical role in a diversified investment portfolio, since they have room to rally more should more serious downside risks to economic growth emerge, and thereby put pressure on equities. Stocks face some near-term challenges as the lower pace of global economic growth impacts earnings momentum. This is particularly relevant if, as we expect, the previously resilient U.S. economy also decelerates in the next few quarters. But with the U.S. Federal Reserve soon likely to join central banks in Canada and Europe in easing interest rates this fall, equities should be supported by better global economic growth expectations beyond 2024.

For Canada, improved productivity, and the resulting lift to profits, could also be one of the keys to allowing our equity market to keep pace with Wall Street, after an extended period of underperformance. Firmer global economic growth could also help in that regard, as it lends a hand to commodities producers. However, we might also need investors to look to diversify away from the technology heavyweights that have been the driver for America’s edge in equity returns.

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