Bank of Canada’s shadow looms over upcoming federal budget

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Central bankers don’t control fiscal policy. But the Bank of Canada’s presence will be stamped all over the approaching federal budget, with Finance Minister Chrystia Freeland under pressure, both politically and economically, to deliver a document that doesn’t get in the way of interest rates coming down.

With borrowing costs near a two-decade high, Ms. Freeland has said her priority for the April 16 budget is creating the conditions for the Bank of Canada to start easing monetary policy. That means keeping the deficit within the fiscal guardrails announced in the fall, while trying to influence the pace of inflation in certain sectors, notably housing.

In recent weeks, the government has pre-emptively announced a series of budget measures targeting the cost of living: a $6-billion infrastructure fund designed to boost home building, a $15-billion top-up to its apartment construction loan program, $1-billion to subsidize school lunches, and expanded coverage of contraceptives and diabetes medications as part of the Liberal’s pharmacare deal with the New Democratic Party.

When it comes to inflation and interest rates, however, what Ottawa leaves out of the budget likely matters more than what it puts in.

“The federal government’s responsibility here is not to screw it up, not to do things that will take us off the course that we’re already on,” said Michael Atkinson, emeritus professor of the University of Saskatchewan’s school of public policy, referring to the downward trend in inflation. “And that’s a worry, given political pressures.”

It’s a tricky spot for an unpopular government with a penchant for spending, one year out from an election.

The trajectory of monetary policy could have a huge impact on the Liberal Party’s fortunes, with high mortgage rates and rising monthly payments bringing the housing affordability crisis to the doorstep of middle-class voters. And tight monetary policy is driving up Ottawa’s debt-service costs, limiting the government’s room for financial manoeuvre.

But the government cannot simply tell the independent central bank to cut interest rates.

In effect, Ms. Freeland and Prime Minister Justin Trudeau need to build an argument for rate cuts with a dose of fiscal restraint. But they also need to appear pro-active on cost-of-living and housing issues, with the opposition Conservatives, led by Pierre Poilievre, hammering the government on affordability, day in, day out.

Over the past two years, fiscal and monetary policy have often rowed in opposite directions.

While the Bank of Canada was pushing interest rates up at a breakneck speed to cool demand and slow inflation, Ottawa and many provincial governments continued to run large deficits and increase program spending.

Meanwhile, government attempts to address the rising cost-of-living – such as the federal “grocery rebate” or provincial “inflation relief” cheques – have tended to put money directly into people’s pockets.

There’s no doubt these measures helped many individuals. But they added to aggregate demand rather than subtracting from it. And the whole point of the Bank of Canada’s restrictive interest rates is to weaken demand for goods and services to curb upward pressure on prices.

“They’ve struggled with a regime change around the issue [of affordability], in that it’s now seen as an inflation problem, not just a household budget discretionary income problem,” said Tyler Meredith, a consultant and the former head of economic and fiscal policy for Ms. Freeland and Mr. Trudeau.

“If it’s a discretionary-income problem, there are ways to supplement that with things like transfers. But if it’s an inflationary problem, it is seen as though the thing that we could do to help people could actually be at odds with how you create conditions for affordability.”

The longer interest rates remain at a two-decade high, the less politically tenable it is for the government to leave inflation control up to the Bank of Canada alone, while it pursues other priorities, such as green industrial policy – the focus of last year’s budget.

Starting last summer, Ms. Freeland and her colleagues have tried to flip the script, announcing a string of measures aimed at lowering inflation for specific goods and services by boosting supply rather than subsidizing demand.

These include tax breaks to encourage apartment construction and stronger competition policies targeting the grocery sector. The recent swathe of prebudget announcements have continued in this vein.

The key question is whether any of these supply-side measures can move the dial on inflation in a time frame that’s meaningful to the Bank of Canada as it prepares to cut interest rates this year.

Most economists welcome increased competition in the grocery sector, and there is a clear need to build more homes to house Canada’s rapidly growing population. But supply-side policy interventions tend to work with a considerable lag.

“The housing issue is an extremely important one for Canadians, so you can’t really fault them for trying to do stuff on that front … or for trying to fix some of the structural challenges we have on infrastructure and service-delivery, given the fact that the population is much larger now than it was a couple of years ago,” said Jean-François Perreault, chief economist at Bank of Nova Scotia.

“But this requires long-term investments that are probably un-impactful, say for the next year or so. Because we know that if you decide to give more money for infrastructure, that money always takes longer to get out the door than anybody would like.”

Some interest-rate relief is likely on the horizon. The annual rate of Consumer Price Index inflation has fallen from a four-decade high of 8.1 per cent back into the central bank’s 1 per cent to 3 per cent control range. Most analysts expect the Bank of Canada to start cutting interest rates in June or July.

The worry on Bay Street, and within the central bank itself, is that increased government spending could extend the timeline for getting inflation back to 2 per cent.

There’s considerable debate among economists about how much government spending drove inflation up in the first place, necessitating the central bank’s historic campaign of rate increases. Mr. Perreault of Scotiabank estimates that government consumption and transfers to households during the pandemic, at both the federal and provincial levels, accounted for around 2 percentage points of the 4.75 percentage points of rate hikes. Other academic and private-sector economists give a much smaller number.

Less debatable is the central bank’s aversion to increased public expenditures at this point in the business cycle.

In a Finance Committee meeting in February, Mr. Macklem told parliamentarians that the current pace of government spending, both provincial and federal, was not adding to inflation.

“That being said, it’s already at the upper end of potential,” he cautioned. “Therefore, if governments were to add more spending, it could start to get in the way of getting inflation back down, and that would not be helpful.”

Provincial finance ministers do not, for the most part, appear to have received the Bank of Canada’s memo. With a few exceptions, the provinces have delivered a string of budgets over the past month defined by rising expenditures, slowing revenues and widening deficits.

This is especially true of the big provinces. Ontario is projecting a $9.8-billion deficit in the coming fiscal year, almost double what it forecast in the fall. Quebec sees an $11-billion deficit, up from a projected $3-billion.

If Ms. Freeland sticks to her promise and meets the fiscal guardrails outlined in the Fall Economic Statement, she may end up as something of an outlier in the federation. The guardrails include a pledge to keep the 2023-24 deficit below $40.1-billion, to put the debt-to-GDP ratio on a downward track starting in 2024-25, and to keep deficits below 1 per cent of GDP beginning in 2026-27.

Meeting these targets is not a given.

The Parliamentary Budget Office projected last month that the 2023-24 deficit would come in at $46.8-billion, and other private-sector economists have published similar numbers. The PBO numbers don’t try to forecast new spending.

Toronto-Dominion Bank economists Francis Fong and James Orlando offered a more optimistic assessment in a recent note to clients. They said the deficit was tracking close to $55-billion, based on monthly data. But this number should shrink to around $40-billion as revenues come in above projections based on stronger-than-expected nominal GDP growth, while “year-end adjustments are expected to swing in the government’s favour.”

While Mr. Trudeau and Ms. Freeland have been making near-daily announcements worth billions of dollars in the run-up to April 16, the fact that this is being done outside of the context of a formal budget means the fiscal implications are unclear. Some of the announcements involve loans rather than grants, while others could be repackaging funding from existing programs. How much of the money being announced is truly new spending will only be made clear on budget day when the accompanying fiscal tables are released.

Avery Shenfeld, chief economist at Canadian Imperial Bank of Commerce, said it’s important to look beyond the headline spending and deficit numbers when trying to assess whether or not the budget is inflationary.

New spending can be neutralized if it’s offset by tax increases, and some spending is actually anti-inflationary if it weighs on specific elements of the Consumer Price Index or stimulates supply rather than demand, Mr. Shenfeld wrote in an e-mail.

“Even a change in the deficit projection doesn’t always come from fiscal stimulus or tightening, since a rising deficit tied to weaker government revenue growth from a softer economy would not be considered to be stimulus that works against interest rate cuts,” he said.

In many ways, the federal government’s most important moves to curb inflation were rolled out earlier this year, when Ottawa announced a two-year cap on international student visas, followed by a limit on the number of temporary residents for the next three years.

Bank of Canada officials have argued in recent months that rapid population growth, combined with the lack of housing supply, is pushing up rents and may explain why real estate prices did not fall as much as they expected when they raised their benchmark interest rate by 4.75 percentage points in 2022 and 2023.

Analysts and central bankers will also be watching the budget for any measures designed to boost productivity. In a late March speech, Bank of Canada Senior Deputy Governor Carolyn Rogers called the country’s low labour productivity and weak levels of business investment an “emergency.” She said that weak productivity growth would make it harder for the central bank to handle inflation in the future without high interest rates.

Getting interest rates down isn’t the government’s only priority. But it’s a major one, and something that could seriously affect the Liberal Party’s popularity heading into the 2025 election.

“If [the Bank of Canada] doesn’t bring down rates, the brunt of the political dimension of the affordability problem is going to continue to be there,” said Mr. Meredith, the former government adviser.

“Because the two things that are really hitting people about this affordability problem are really the cost of essentials, and the cost of housing.”

With a report from Bill Curry