Canada’s two-track economy

Key Concepts

• Two-Track Economy: An economic state where different sectors or regions experience divergent growth patterns (e.g., energy-producing vs. energy-importing regions).
• Oil Price Shock: A sudden increase in oil prices that acts as a catalyst for regional economic disparity and inflationary pressure.
• Negative Wealth Effect: A psychological and economic phenomenon where a decline in asset prices (like equity markets) leads consumers to reduce spending.
• Supply Shock: An event that suddenly changes the price of a commodity or service, often leading to broader inflationary trends.
• Capital Investment: Spending on physical assets (defense, infrastructure) versus business investment in productivity.

1. Snapshot of the 2025 Canadian Economy

The Canadian economy experienced its slowest annual growth since 2020, recording a 1.7% increase. Key performance indicators include:

• Trade: Exports to the U.S. fell by 1.7%, while imports declined by 0.4%.
• Spending: Household spending rose 2.3%, though this was largely attributed to the rising costs of mortgages and rents rather than increased consumption.
• Investment: Total capital investment grew by 1.4%, heavily skewed by government spending (Defense +46%; Engineering structures +6.7%). Business investment remained stagnant at 0.3%, marking the third consecutive year where government spending outpaced business investment, despite a 7.4% rise in corporate profits.
• Sector Performance: Manufacturing (10% of GDP) struggled, while the energy sector (10% of GDP) performed better.

2. Regional Economic Disparity

Jean-François Perrault, Chief Economist at Scotiabank, highlights that Canada is currently experiencing a "two-track economy" driven by oil price volatility:

• Beneficiaries: Oil-producing regions, specifically Alberta, benefit substantially from rising energy prices.
• Affected Regions: Energy-importing provinces like Ontario and Quebec face higher costs, which negatively impact their economic outlook.
• Forecasts: Economic projections are currently highly sensitive to the duration of global conflicts and the resulting price of oil, which has reached $110 per barrel.

3. Inflation and Monetary Policy

Perrault emphasizes that inflation is a primary concern, with projections ranging between 3.5% and 4%.

• The "Temporary" Fallacy: Perrault argues that central banks previously made a mistake by labeling supply shocks (pandemic, Ukraine war) as "temporary."
• Shift in Strategy: Central banks have learned from past inaction. The current stance is to avoid "taking a chance" on inflation being transitory. If inflation broadens beyond energy costs, central banks are prepared to act aggressively.
• Interest Rates: Rate cuts are not currently on the horizon. Central banks face the difficult task of potentially raising rates in an environment where the underlying economy is not robust.

4. Market Outlook and Risks

• Conflict Duration: The economic outlook is tethered to the duration of the current geopolitical conflict. If oil prices escalate to $150–$200 per barrel, inflation will likely accelerate significantly.
• Wealth Effect: A significant correction in equity markets poses a risk of a "negative wealth effect," where declining asset values dampen consumer confidence and spending.
• Market Pricing: Financial markets are already pricing in higher inflation for 5, 10, and 30-year instruments, reflecting the expectation that central banks will prioritize inflation control over economic stimulus.

5. Notable Quotes

• "It’s a scenario where I don’t think rate cuts are on the horizon at all." — Jean-François Perrault, regarding the current monetary policy environment.
• "You might have to raise interest rates in an environment where inflation’s going up and the underlying economy perhaps isn’t as robust as you want it to be." — Jean-François Perrault, on the dilemma facing central bankers.

Synthesis and Conclusion

The Canadian economy in 2025 is characterized by sluggish business investment, a reliance on government spending for growth, and a stark divide between energy-producing and energy-importing regions. The primary takeaway is that central banks have shifted their philosophy: they are no longer willing to treat supply-side inflationary pressures as temporary. Consequently, the economy faces a period of high interest rates and potential volatility, with the outlook heavily dependent on the duration of global geopolitical conflicts and their subsequent impact on commodity prices and consumer confidence.