What Governments Giveth, the Bank of Canada Taketh Away

It’s been a challenging year for many Canadians. Sure, the pandemic is largely behind us. Jobs are bountiful and wage growth is near the highest it’s been in a decade. But that’s cold comfort when inflation has risen even faster, leading real wages lower. Then there’s the impact of interest rate hikes intended to return price growth to the Bank of Canada’s low, stable and predictable two-percent target. This has caused interest-rate sensitive asset values and parts of the economy to beat a hasty retreat. Since their home is the largest asset of most households, many Canadians are seeing the value of their nest egg cracking at the same time that their monthly mortgage payments are getting harder to make. Consumer spending has slowed as a result, and will likely weaken further as Canadians do whatever they can to stay in their homes. (See our latest Economic and Financial Outlook External link. This link will open in a new window. for additional details on our most recent forecast.)

Into this environment came calls for governments to provide inflation relief. And provinces were the first to answer the call. Some chose to cut gas taxes and fees. Still others cut cheques to their citizens, with some providing targeted transfers, while others were less discriminating. The size of the measures also varied considerably, ranging from 0.1% to 1.0% of regional GDP, with Quebec dwarfing all other provinces on a per capita basis. Together, these measures are expected to increase growth by 0.1 percentage points this year. (See our recent analysis on the provincial fall fiscal releases here External link. This link will open in a new window..)

Then you have the federal government. Despite consistent calls for income support, they held out longer than most. But they eventually turned on the taps too. First, they doubled GST payments, increased the Canada Housing Benefit, and pushed through a federal dental program. Then, in the Fall Economic Statement, they topped it up with changes to the Canada Workers Benefit and the elimination of interest on student loans. All in, this amounted to $3.2B in the current fiscal year. But the overall economic impact isn’t expected to amount to much, adding less than 0.05 percentage points to real GDP growth in each of 2022 and 2023. (See our recent analysis on the federal fiscal outlook here External link. This link will open in a new window..)

But regardless of the size and scope of the announced measures, one thing is clear: they are inflationary. During economic downturns, this is in part the intent of fiscal stimulus. But at a time of excess demand, any amount of procyclical stimulus is going to be more inflationary than it would be otherwise. This makes the job of the Bank of Canada more difficult. High inflation could push the Bank to hike the policy rate further and/or keep it elevated for longer. Indeed, the most recent 50 bps hike was far from baked in. It no doubt reflected the upside surprise to Q3 real GDP (despite a contraction in domestic demand). Upward historical revisions to real GDP pointed to more excess demand than previously expected, which likely didn’t help much either. And now our Q4 real GDP growth tracking is well above the Bank’s 0.5% annualized forecast in the October 2022 Monetary Policy Report. This spells further upside risk to the output gap when the Q4 real GDP number is published, meaning more potential domestic pressure on inflation down the road.

A scenario of sustained high inflation would mean only one thing: higher rates for longer. Indeed, what governments giveth, the Bank of Canada taketh away. Governments need to be mindful of this as they think about rolling out more spending measures, no matter how well intended. With a likely recession around the corner, fiscal authorities should keep any future income support small, targeted and time-limited, letting automatic stabilizers like Employment Insurance do more of the heavy lifting. Any remaining dry powder should be directed toward making investments that will increase long-term productivity and prosperity, such as infrastructure. While this won’t make Christmas any less merry, it will certainly make for a happier New Year.