The Bank of Canada (BOC) is understandably hesitant to change the monetary policy rate. It has been on hold since July 2015, a steadying presence amid complex developments in the regional and global economy: the oil price shock, the Alberta wildfire, the housing boom in Toronto, the Brexit and Trump surprises. Despite seeing two quarters of stronger Canadian growth, the BOC is unlikely to hike in 2017, setting a high bar given ongoing risks and uncertainties (U.S. trade policy, oil prices, infrastructure investment, consumer spending). The BOC is thinking long term and would like to actually see fiscal policy, business fixed investment and exports further stimulating economic growth.
The April BOC monetary policy statement was mildly hawkish: It acknowledged the recent stronger growth and better-than-expected economic data, yet revised down the forecast for the potential GDP growth rate. We still think that the Bank of Canada is on hold for 2017, mindful of the range of uncertainties over the horizon as well as serial disappointments thus far in the Canadian recovery.
U.S. policy – especially trade – is by far the greatest source of uncertainty to Canada’s outlook. Any movement toward U.S. protectionism would have a major negative impact on the Canadian economy. Recognizing this risk, the BOC mentions U.S. trade policy often in the latest Monetary Policy Report.
The reliance on U.S. policy highlights one of the weak points in the Canadian economy: its persistently underwhelming exports, especially in non-commodity sectors. A key question for policymakers is whether this weakness is structural or cyclical. The BOC needs more time and data to make that assessment.
Housing boom and indebted consumers
The housing market is clearly a concern for the BOC. Its 2017 forecast revised down housing’s contribution to GDP growth, demonstrating caution on the Toronto housing market as its boom continued in the first quarter of this year. The surge in home prices presents real risks to the macro economy, and residential investment and consumption as a percentage of GDP is very high by historical standards. As people “consume” a lot of housing and go deeper into debt doing so, they effectively borrow that consumption from the future. This means we can’t rely on Canadian consumers to be the main drivers of real GDP growth the way they have in the past – a vulnerability the BOC has consciously incorporated in its growth forecast.
Anemic business investment
Another uncertainty keeping the BOC in pause mode is the overall lack of investment in the non-commodity sectors. Usually at this point in a recovery cycle, businesses kick into higher gear, building and growing, but this time they are taking a wait-and-see approach instead. And this isn’t just about Canada: One thing that’s characterized the global economy’s recovery from the 2008–2009 financial crisis is the lack of business investment. It’s likely a kind of aftershock from the crisis. Wary business leaders may be willing to take on some risk, issue debt, buy back stock or ponder acquisitions, but overall they hesitate to commit to long-term investments in plants and equipment that are the true sign of confidence in future economic growth.
That said, the global economy is still moving upward in a very long if tepid expansion, and so long as we don’t see any downside shocks from U.S. policymakers, at some point business investment will finally grow in Canada. This is still a business cycle. Over time, we can expect to see a rotation away from the consumer and residential investment toward more business-focused investment as a key driver of Canada’s economy, but this is a tricky handoff and may not be smooth.
Fiscal discipline, fiscal stimulus
It’s worth remembering that relative to many other developed markets, Canada is in pretty good shape. Yes, the economy’s reliance on commodities caused some pain in the past couple of years, but both the debt and deficit relative to GDP are reasonably low, which made the fiscal stimulus in last year’s budget a prudent decision. A key question going forward is whether we can expect continued fiscal discipline as growth picks up and the Canadian economy steadies over the long run. This spring’s budget was a wait-and-see budget, which made sense to us given all of the uncertainties in the U.S. and elsewhere. While innovation is one key budget theme as fiscal policymakers look to promote productivity growth – the magic bullet to improving government revenues in the future – it has been elusive thus far. Since the Canadian economy has improved in recent months, we bond investors will be watching whether the government uses higher-than-projected revenues to pay down debt or increase spending. We think investors will reward prudent fiscal discipline so Canada can be prepared for future shocks and recessions.
Another key fiscal initiative is the new infrastructure bank, announced late last year (as part of a broader infrastructure investment program) with plans to begin operation by the end of 2017. With a C$35 billion stake, the infrastructure bank could be a tremendous boost or it could be a mess – the devil is in the details. Canada could learn something about what not to do from the U.S., where the implicitly government-guaranteed agencies of Fannie Mae and Freddie Mac ended up being explicitly backed when things turned sour in 2008, with much pain ensuing for investors and taxpayers. It’s important that Canada’s infrastructure bank be well-financed and organized and not a form of quasi-off-balance-sheet debt. The fact the government keeps extending the timetable on the bank’s launch is hopefully a sign of prudence – someone is minding those details and learning those lessons in an effort to get it right.
Meanwhile, the Bank of Canada will be watching and waiting.