Trudeau and Poloz Are On an Economic Collision CourseBy
Should stimulus removal begin on the monetary or fiscal side?
Fiscal update due Tuesday; Bank of Canada decision Wednesday
Canadians only get six major economic “report cards” from federal policy makers every year -- four quarterly monetary policy reports from the Bank of Canada, a federal budget typically early in the new year and a fiscal update some time in fall.
So, it’s rare when these releases juxtapose as they will this week with Finance Minister Bill Morneau’s update Tuesday, and Bank of Canada Governor Stephen Poloz’s MPR Wednesday. It’s fitting too, given fiscal and monetary policy in Canada are potentially on a collision course.
The two reports will essentially tell the same story about the economy -- that it’s on the strongest footing in years. Policy makers will get the opportunity to crow: both fiscal and monetary policy have clearly played key roles in the economy’s recent success. The federal government is expected to spend some of the additional revenue on programs, including its marquee Canada Child Benefit.
Yet the economic strength also poses new challenges. For one, it makes the case for deficits less compelling, since the spending threatens to crowd out other parts of the economy. In fact, any additional federal stimulus could trigger further interest rate increases.
“With the economy near full capacity, any fiscal stimulus is likely to be inflationary -- prompting an offsetting response from the Bank of Canada,” Josh Nye, an economist at Royal Bank of Canada, wrote in a preview of the update. “We think the government’s improved fiscal position would be put to better use by returning to a balanced budget.”
Over the past year, Canada’s economy has been running at a pace rarely seen in the past couple of decades, rapidly eliminating spare capacity and prompting the central bank to raise interest rates twice since July. Economists are projecting 3.1 percent growth in 2017, easily the best in the Group of Seven.
A synchronized global recovery and rising trade volumes are backstopping the growth. The bottoming of the oil shock in western Canada is also helping, along with rising industrial production in developed economies and soaring home prices in Toronto and Vancouver. Government policy has also helped. Federal deficit spending, particularly the enhanced child benefit system, has undeniably been fueling consumption.
The bottom line, documents Tuesday will probably show, could be C$50 billion ($40 billion) less in cumulative deficits over the next five years, absent any new spending measures from Prime Minister Justin Trudeau’s Liberals. Essentially, the economy is telling policy makers it doesn’t need as much stimulus as it did only six months ago.
That poses a problem for an administration that has put government at the forefront of its economic agenda. The Bank of Canada meanwhile is going through a similar exercise, and taking advantage of growth to bring interest rates back to something approaching normal. Investors are betting another rate increase is in the cards by January, though not this week, after two hikes since July.
The dilemma becomes what stimulus should be removed first -- monetary or fiscal?
A case can be made for bigger government combined with more higher borrowing costs. There’s an economic case for redistributing income more fairly and financing productivity-enhancing infrastructure, if the government could figure out how to get money out the door for those projects.
Tuesday’s update will contain new measures including the expansion of child benefits, according to a report by the Canadian Broadcasting Corp. Last week Trudeau unveiled a cut to the small-business tax rate that will lower revenue by about C$2.9 billion over five years, beginning in 2017-18.
Larger government deficits, coupled with less private debt and tighter monetary policy could even be seen as a stabilizing force for an economy with record household leverage. Trudeau’s Liberals have already taken the political lumps for deficits. They might as well enjoy the spoils.
“To the extent that fiscal policy undertakes actions that provide a little bit more firepower to the economy, it gives the bank greater flexibility in terms of raising interest rates and trying to impact household spending and borrowing behavior,” Jean-Francois Perrault, chief economist at Bank of Nova Scotia and a former finance department official, said by phone from Toronto.
But such a scenario -- even if it was desirable or politically feasible -- isn’t in the cards partly because it requires a level of coordination between the government and the central bank that currently doesn’t exist.
Instead, expect a heavy dose of caution, centered on looming risks. These could range from the collapse of Nafta to the slowdown of Toronto and Vancouver housing markets or even another U.S. recession.
For Morneau and the governing Liberals, heightened uncertainty can be used to argue against rushing to balance or taking up fiscal leeway.
The Bank of Canada is likely to use some of the same arguments for remaining circumspect on rates.