Washington, DC – The International Monetary Fund states that, “Canada has come through the pandemic relatively well and, as a commodity exporter, has been hit less hard than many other countries have been by the war in Ukraine”.
Nonetheless, inflation is well above target, housing affordability is a major concern following a long boom that may now have peaked, and the pandemic remains a source of risk.
The IMF reporting on Canada state that the economy is expected to see a substantial further cooling, with risks to growth tilted to the downside, and shocks could easily push the economy into a mild recession.
The IMF adds, “Continued monetary and fiscal tightening will be needed to rein in inflation, and further policy measures—particularly on the supply-side—would help to address housing affordability over time. Canada has a history of prudent fiscal policymaking, but the fiscal framework could be better anchored with a specific debt target supported by an operational rule. Rules-based fiscal stimulus could also be a useful addition to the policy toolkit for dealing with future downturns. There is also scope to enhance some areas of financial regulation”.
David Coletto, CEO, Abacus Data says, “Today, only 9% say the economic conditions for them personally are relatively good, while 53% say things “could be better but are not really difficult.” Just over a third (38%) say things are really difficult for them at the moment.
“While the number of people who say things are “really difficult“ is exactly the same as in July, there has been a five-point increase in the number who say things for them “could be better but were not really difficult” and a corresponding drop in the number who feel things are relatively good”.
IMF on Climate Change
Finally, on climate change, from a challenging starting point of high emissions, Canada has laid out ambitious plans for camrbon pricing and would be well placed to help catalyze international agreement on a differentiated carbon price floor. At the same time, a comprehensive strategy is needed to help the economy transition away from carbon-intensive products and processes and to assist affected workers, communities, and regions as the world moves toward net-zero emissions.
Recent Developments and Outlook
Macroeconomic policies have been tightened. The Bank of Canada (BoC), which had started tapering asset purchases as early as October 2020, began reducing the size of its balance sheet and raising policy rates in March 2022. The BoC has now hiked by a cumulative 300 bps, leaving the policy rate at 3.25 percent, and has indicated that further rate increases will be forthcoming. With emergency pandemic support now unwound, the fiscal stance has also tightened.
The economy has started cooling in response. While growth continued to be strong in the first half of this year, supported by the relaxation of pandemic restrictions and the improvement in Canada’s terms of trade, more recent indicators, such as retail sales, suggest a slowing of activity. Labor-market conditions remain tight, with elevated vacancies, but they may be easing, bolstered by a return of immigration—the unemployment rate is now half a point above the historic low of 4.9 percent reached in June. And inflation, which rose to 8.1 percent in June, has now retreated to 7 percent, with core inflation just under 6 percent.
Policy tightening has also triggered a welcome housing correction. Canadian housing markets—which had already been hot for two decades—were pushed to unsustainable heights during the pandemic. Sales surged and average prices climbed more than 50 percent from April 2020 to February 2022, fueled by low interest rates (notwithstanding the application of a stringent borrower stress test), preference shifts since the start of the pandemic, healthy household incomes, and perhaps also some self-fulfilling investor behavior (e.g., a “fear of missing out”). But with rates now up sharply, house prices have started to come off their peak even as rents have continued to rise, supported in part by the post-lockdown return of student populations.
Financial stability risks are rising, but the system should be resilient to the tightening cycle. Banks are generally well capitalized and liquid, they are seeing their net interest margins widen as rates rise, and the majority of their main borrowers are expected to remain sound—households generally should be able to continue servicing their mortgages, [1] and listed nonfinancial corporates are healthier than in the past. Nonbanks, including Canada’s large pension funds and insurers, also appear to be financially healthy, although comprehensive data are not publicly available. Following their search for yield over the past decade, they are now holding a larger share of riskier and less liquid assets while relying on repo financing and derivative hedging, but it appears that they generally weathered the “dash for cash” episode in March 2020 relatively well, and they should be well positioned to avoid liquidity squeezes going forward.
Staff expect a substantial further cooling of the economy, with growth risks skewed to the downside, and shocks could easily push the economy into a mild recession. Growth is expected to slow in the second half of the year, registering 3.3 percent on average in 2022 and 1.5 percent in 2023, while unemployment could rise to above 6 percent. With continued resolute policy tightening, inflation is expected to continue slowing, reaching the 2-percent target by end-2024. Driven by rising rates, house prices are expected to retrace much of their pandemic run-up, falling 20 percent or more from their peak, with rising immigration cushioning the decline. The economic outlook could, however, be substantially worse. If inflation remains higher than in the baseline, this could trigger sharper BoC tightening and a more pronounced deceleration of activity. A more abrupt slowdown in the rest of the world—and particularly in the U.S., given the close integration of the two economies—would also have an important impact on Canada. A mild recession could easily emerge, and the historical distribution of risks suggests a roughly 10-percent chance that the economy would contract for 2023 as a whole.
Supporting Affordability
Bringing inflation swiftly back to target is key. The BoC should continue reducing the size of its balance sheet and will likely need to continue hiking the policy rate to at least 4 percent by end-year and remain around that level for several quarters in order to put inflation decisively on a downward path while achieving the soft landing described above. Rates could well need to move even higher, especially in light of the Federal Reserve’s recent decision and forward guidance, which could have implications for the exchange rate and thus bring further inflationary pressure. On the other hand, a faster normalization of global supply chains or faster phase-out of pandemic restrictions in China could help to lower inflation and boost output in Canada, calling for a less aggressive rate path.
Fiscal policy should support the fight against inflation. Revenue windfalls at both federal and provincial levels should be saved, and while some space could be made for limited and highly targeted programs to buffer vulnerable households from high fuel and food prices, more generalized spending increases should be avoided so as not to undercut monetary policy. The trajectory of deficit reduction from next year’s budget onward could also be made more ambitious, helping not only to rein in inflation but also to bring debt down more quickly.
Further policy measures are needed to support housing affordability. Rising interest rates will make housing less affordable in the short-term, but as they curb demand and reduce prices—and thus required down payments too—homeownership should, over time, become more affordable, especially for younger and cash-constrained households. That said, additional policy steps to promote affordability would be useful, particularly on the supply side, which remains the key, long-term constraint:
· The new Housing Accelerator Fund should help boost housing development, but additional measures at the local level to expedite the permitting process and promote densification are needed and could be complemented by additional federal support for critical infrastructure.
· The case for demand-side measures is more nuanced. Since the housing correction is expected to be orderly, the Office of the Superintendent of Financial Institutions’ (OSFI’s) stated intention not to loosen the stress test appears appropriate. Targeted support, as in the budget, could help first-time homebuyers and other grou ps but, if scaled up or generalized, could add to demand and worsen affordability. Measures to disincentivize investors and second homebuyers—e.g., increased stamp duties and capital gains taxes, or lower LTV limits—could be helpful in easing affordability (although implications for the rental market would need to be considered carefully); such measures may also boost aggregate productivity by reallocating investment.
Strengthening the Policy Toolkit
Canada has a history of prudent fiscal policymaking, but over the medium-term, the fiscal framework could benefit from the adoption of an explicit debt anchor and supporting operational rule. The federal government’s commitment to deficit reduction and publication of long-term projections are welcome steps toward strengthening the fiscal framework, but policymakers’ specific goals remain unstated. Adopting a specific debt anchor, supported by an operational rule to determine how the fiscal position reverts to the debt anchor following shocks, would help to guide market expectations, enhance credibility and accountability, and ultimately reduce the output costs of consolidation. Oil-rich provinces appear to have been prudent in saving the bulk of their recent revenue windfalls, but codifying this via rules designed to shield provincial budgets from commodity-revenue volatility would be beneficial.
Fiscal policy could be further enhanced through the adoption of rules-based automatic stimulus. Such a mechanism would mandate temporary spending increases (e.g., on household transfers) based on a pre-set macroeconomic trigger, such as a rise in unemployment above a certain level. By providing a clear signal of government support to households and firms, it would reduce their uncertainty and induce them to spend more, thus helping the economy to recover faster. And by combining the rapid implementation of monetary policy with the rapid effectiveness of fiscal policy, rules-based stimulus could be a useful addition to the policy toolkit for handling future downturns.
Improved communication enhances the effectiveness of monetary policy. The recent decision to start publishing summaries of Governing Council deliberations is welcome and brings the BoC in line with global best practice. And the introduction—in the July Monetary Policy Report—of scenario analysis should help markets appreciate the key risks. To deepen markets’ understanding of the BoC’s decisions, other improvements could be considered: the Bank could add more quantitative discussion of changes in the policy stance associated with alternative scenarios, to complement its qualitative guidance on the policy rate, and also publish the rate path underpinning the quarterly economic forecast, although it would be important to make clear that this is not a commitment and that policy would respond to incoming data in order to return to the inflation target.
Some steps could be taken to enhance financial regulation. First, there is a need to establish a clear regulatory regime for cryptoassets, and OSFI’s recent publication of an interim advisory on cryptoasset exposures, along with Finance Canada’s ongoing work in this area, are important steps in this direction. The AML/CFT framework requires some improvements—in particular, with regard to the risk-based supervision of designated nonfinancial sectors such as real estate, casinos, and the legal profession—and the planned introduction of a federal beneficial-ownership registry in 2024 should be followed by similar, compatible initiatives at the provincial level, where the vast majority of corporates are registered. Finally, there is scope to further build on progress to date in improving interagency cooperation among federal and provincial financial regulators and supervisors.
Transitioning to a Low-Carbon Economy
Canada aims, by 2030, to cut emissions to 40-45 percent below 2005 levels. From a challenging starting point as the world’s eighth-largest CO2 emitter, and with the highest per-capita emissions of any major economy, Canada has laid out ambitious and welcome policy plans including a steady increase in the federal carbon tax to CAD 170/ton by 2030—one of the highest levels proposed internationally—and the authorities have underscored their continued commitment to this goal. Given its climate ambition, Canada is well placed to catalyze an international agreement on a carbon price floor, a collaborative solution that could be differentiated by development level and could move the world decisively toward meeting its mitigation objectives. Industrial competitiveness issues will also need to be considered carefully in the light of countries’ differing policy approaches. Finally, Canada is a role model for other advanced economies in its generous commitments of climate financing for developing nations.
Particular attention should be paid to transition risks:
· As the world decarbonizes, oil and gas demand will decline, putting pressure on exporting nations. Given the high upfront capital needs but low ongoing operational costs of much of Canada’s oil production, many existing projects may remain in production for an extended period—albeit with reduced profitability as global producer prices fall. New developments, however, may become uneconomic, and incentives should not actively be provided for projects that may result in stranded assets.
· At the same time, a comprehensive strategy to transition the economy and its workers away from carbon-intensive products and processes will be needed for the medium- to long-run. This may require some fiscal support, while maintaining a prudent overall fiscal stance: tax credits and other policies could incentivize private green investments (including in critical “transition” minerals and clean fuels), and direct public green investments will also be needed. Policies for a “just transition” will be critical—protecting those, including First Nations, whose lives and livelihoods may be threatened by decarbonization, helping workers redeploy their existing technical skills in greener activities as well as training them in new skills, and providing for regional development and diversification. The BoC may also be able to play a role in the climate transition, consistent with its mandate.
