For the first time in a decade, Canada’s policy makers are worrying the economy is running too hot instead of too cold.
The federal government and Bank of Canada are set to release key reports that will paint a picture of an economy running at full steam, with the jobless rate at near-historic lows, consumer spending and housing holding up in the face of rising interest rates, and businesses starting to invest again. A booming U.S. economy, coupled with averting a trade war with Canada’s biggest trading partner, is only stoking growth.
The problem is the Canadian economy is no longer built for speed, given its aging workforce and a long record of business under-investment. This poses a new set of problems for policy makers, in particular how quickly to put the brakes on the expansion before it overheats and what to do about structural issues that limit how much the economy can grow.
“Essentially what’s happening in the Canadian and U.S. economies is these economies are sprinting in the middle of a marathon and that will lead to exhaustion,” Frances Donald, head of macro strategy at Manulife Asset Management, said in an interview.
Most analysts believe 2 per cent growth is the Canadian economy’s absolute top speed limit, before inflation begins picking up. But demand is growing more quickly than that. Last year, growth actually exceeded that pace by more than a full percentage point and is expected to remain above 2 per cent over the next couple of years.
While there is little evidence of overheating just yet, warning signs are starting to appear with companies running up against capacity constraints and complaining they can’t find workers to expand.
One question this raises for policy makers is how much will they need to slow everything down. The economy is awash in stimulus in the form of cheap credit from Bank of Canada Governor Stephen Poloz and deficit spending by Prime Minister Justin Trudeau that it no longer needs. Another question: Is there anything they can do to raise the country’s so-called speed limit and reduce the capacity constraints the economy is facing?
The Bank of Canada’s efforts to cool the economy are already underway. The central bank has increased rates four times since last year, and investors are expecting at least three more hikes over the next 12 months including one at a rate decision Wednesday. The monetary policy report that will accompany the rate decision should provide more insight into how quickly Poloz and his team plan to move again.
“The Canadian economy is a case of too much of a good thing and we think the Bank of Canada is even behind the curve a bit” on rate increases, said Jean-Francois Perrault, chief economist at Bank of Nova Scotia, who expects the central bank’s policy rate to double from current levels by early 2020.
Up until now, Trudeau’s Liberal government has shown no interest in withdrawing its stimulus. Its fiscal plan — which will be updated in coming weeks (no release date has been published) — has been essentially to keep expenditure levels and deficits elevated until at least after next year’s federal election.
This opens the Liberals to criticism they are taking on debt for little gain, given the economy is running at capacity and the central bank is trying to cool it down. A faster draw down of deficits would theoretically ease pressure for rate hikes, a plus for the country’s most indebted households, who are disproportionately young urban families with huge mortgages in places like Toronto.
“At this point of the cycle you want to see surpluses and paying down debt,” said Craig Wright, chief economist at Royal Bank of Canada.
At the same time, it’s hard to argue Canada’s deficits — which aren’t growing — are out of control. Nor is fiscal policy a great tool to fine tune a soft landing for the economy. Government is just not that nimble, even if the Liberals wanted to slow things down.
The government can also counter that its deficits are addressing some of the structural issues constraining the economy’s potential growth rate. The tax cuts Finance Minister Bill Morneau is expected to announce in his budget update fall into this category. So do some other policy initiatives the Liberals have undertaken, like increasing immigration levels to alleviate some of the labour shortages, spending more on infrastructure and trying to get more women into the labour force.
The truth, however, is the bulk of the government’s deficit spending — the Liberals ran combined deficits of $38 billion in their first two budgets, or just under 1 per cent of output — went to finance other priorities.
“Most of it in my opinion is not productivity enhancing,” said Randall Bartlett, chief economist at the Ottawa-based Institute of Fiscal Studies and Democracy.
With assistance from Erik Hertzberg