ECONOMISTS SURVEYED
Douglas Porter, BMO
Avery Shenfeld, CIBC
Stéfane Marion, National Bank
Craig Wright, RBC
Aron Gampel, Scotiabank
Warren Jestin, Scotiabank
James Marple, TD

Since the financial crisis of 2007/08, the models that economists, investment analysts, and managers use have come in for much criticism and increased scrutiny regarding the realism of their structures and assumptions.

Virtually all practising economists today use economic models based on the neoclassical synthesis – i.e., a combination of neoclassical economics (which relates supply and demand to individuals’ rationality and ability to maximize utility or profit) with the macroeconomic thought of John Maynard Keynes (which holds that, in the short run, especially during recessions, economic output is strongly influenced by aggregate demand or total spending).

Such models can’t generate the kind of instability seen during the financial crisis and the Great Recession that ensued, since the models assume away certain factors, such as financing arrangements centring around banks and money creation, constraints imposed by debt, behavioural effects, and the problems associated with uncertain futures.

“Their median unemployment rate forecast for year-end 2016 is 6.8 percent, unchanged from 6.8 percent at year-end 2015”

Behavioural effects encompass the influence of psychological, social, cognitive, and emotional factors on the economic decisions of individuals and institutions. They also include reflexivity, i.e., feedback loops, such as the self-reinforcing effect of market sentiment. In such a situation, rising prices attract buyers whose actions drive prices higher still until the process becomes unsustainable, and then the same process operates in reverse, leading to a collapse in prices.

Former U.S. Federal Reserve chair Ben Bernanke is an expert on both economic and market crashes of the last 100 years, from the Great Depression of 1929 through the early 1930s to the 2007/8 financial crisis. On the topic of standard economic models, his comments in 2010 are particularly noteworthy:

Standard macroeconomic models such as the workhorse new Keynesian model did not predict the crisis, nor did they incorporate very easily the effects of financial instability. Do these failures of standard macroeconomic models mean that they are irrelevant or at least significantly flawed? I think the answer is a qualified no. Economic models are useful only in the context for which they were designed. Most of the time, including during recessions, serious financial instability is not an issue. The standard models were designed for these non-crisis periods, and they have proven quite useful in that context.

So, with Bernanke’s words in mind, what are some of Canada’s economists forecasting for 2016, and what are their notable (and qualifying) assumptions using models based on the neoclassical synthesis?

As shown in Table 1, the six chartered banks’ economists have a median real GDP growth forecast of 2.1 percent in 2016, up from 1.2 percent in 2015. Scotiabank and National Bank are predicting the weakest growth, with 1.7 percent and 1.6 percent, respectively, and RBC forecasts the strongest, at 2.3 percent.

Their median unemployment rate forecast for year-end 2016 is 6.8 percent, unchanged from 6.8 percent at year-end 2015. Not surprisingly, in light of their GDP forecasts, Scotiabank and National Bank predict the highest rates (6.9 percent) and RBC and BMO the lowest (6.5 percent). For headline CPI, the median forecast is 2.0 percent in 2016, up from 1.2 percent in 2015, with only National Bank (1.7 percent) varying materially from the median. The median forecast for the Canadian dollar at year-end 2016 is US$0.76, up slightly from US$0.75, with National Bank (US$0.73) at the low end of the range and BMO (US$0.78), CIBC (US$0.78), and RBC (US$0.77) toward the higher end.

Only RBC and CIBC are predicting a change in the Bank of Canada’s overnight target rate by year-end 2016 (up 75 basis points to 1.25 percent and 25 basis points to 0.75 percent, respectively). Two-year rates are widely expected to be substantially higher, rising to a median of 1.12 percent by year-end 2016 from 0.53 percent at year-end 2015, with Scotiabank’s forecast (1.80 percent) and RBC’s (1.75 percent) being the highest and TD’s (0.90 percent) and BMO’s (1.00 percent) the lowest. Finally, the economists’ median forecast for the Government of Canada 10-year yield at year-end 2016 is 2.30 percent, up substantially from 1.73 percent at year-end 2015. RBC makes the highest prediction (2.90 percent) and BMO the lowest (1.90 percent).

All six economists are expecting a fairly stable Canadian–U.S. dollar exchange rate, stable to modestly higher oil and gas prices along with those of most other commodities, and real GDP growth of at least 5 percent in China. Important assumptions include no major political, financial, or commodity market shocks; continuing stimulative monetary policy in the eurozone, with no euro exits or defaults; no major disruptions in global oil supply beyond those now in evidence; no U.S. government shutdowns over budget impasses with Congress; and no major new federal spending cuts or tax hikes in Canada or the U.S.

Among the Canadian provinces, Alberta is expected to undertake significant fiscal stimulus, while Quebec and Ontario are expected to restrain operating spending, although Ontario is expected to proceed with major capital plans.

The main drivers of Canadian economic growth in the next year are expected to be the low Canadian dollar, the resurgence in U.S. economic growth (expected to range from 2.3 percent to 3.0 percent), improving trade, continuing moderate growth in household spending, and the diminished effects of capital spending cuts in 2016 compared to 2015.

Economists’ economic models—such as the capital asset pricing model in investment management and the value at risk model in risk management—provide useful analyses of the performance we can expect from economies, assuming they aren’t derailed by unforeseen geopolitical, financial, or commodity price factors, or any of the other factors mentioned above. As such, the models cease to be illuminating and become misleading only when they’re put to uses that fail to take into account their inherent limitations or are relied on in a manner or to an extent that is unrealistic.

As Scotiabank’s economists put it sagely and realistically, “Renewed financial market volatility attests to the chronic economic strains and elevated geopolitical risks internationally. And businesses, investors, policymakers, as well as economists alike are all having a difficult time trying to understand [them] and navigate through the unprecedented challenges. In this environment, judgmental solutions are probably just as good as model-based results.”

The main drivers of Canadian economic growth in the next year are expected to be the low Canadian dollar, the resurgence in U.S. economic growth, improving trade and household spending, and the diminished effects of capital spending cuts in 2016 compared to 2015.