The thirteenth month

According to data released today by the Department of Finance, Canada's Federal budget deficit was C$ 314 billion for fiscal year 2020/21, which ended at the start of April. That's by far the largest deficit ever recorded, but it's significantly lower than the C$ 354 billion figure announced by Finance Minister Chrystia Freeland when she tabled her budget at the end of April, and even further below the C$ 380 billion that the Federal Government was projecting late in 2020. 

That sounds like (relatively) good news, but there's one complication.  A regular feature of Canadian Federal finances is the so-called "thirteenth month".  Under the guise of ensuring that expenditures and revenues are recorded in the correct period, the Department of Finance customarily keeps the books open for several months after each fiscal year actually ends. Today's data are already accompanied by a warning that the final deficit figure will be boosted by C$ 7 billion in new spending introduced in the budget. It is highly likely that there will be other adjustments to be made.  

The picture is further muddied by the fact that the Government is clearly gearing up to hold an election as soon as it decently can, which is to say, as soon as it can reasonably argue that the COVID pandemic is in full retreat. The government is unlikely to avoid the temptation to use the "thirteenth month" to portray the fiscal situation in the most advantageous electoral light. The final figure that appears toward the end of this calendar year may bear little resemblance to what was announced today. 

Cross-purposes

Canada's Parliamentary Budget Officer (PBO) continues to pick away at the Federal Budget that was tabled last month. The latest report attempts to quantify the impact of the budget on real growth and inflation, and also warns that increasing rising rates could offset part of the fiscal stimulus that the budget is designed to provide.  

The fiscal stimulus in the budget initially looked substantial. The Government touted about C$ 143 billion in new spending over the next five fiscal years, but the PBO's initial analysis of the budget showed that actual new spending is substantially lower, at about C$ 114 billion. (See blog post dated May 6 for a summary of that analysis). In line with that initial take, the PBO's latest report suggests the budget's impact on growth will be small, adding 0.6 percentage points to growth this year and 0.3 percent in 2022. Intriguingly, it also estimates that GDP in 2025 will be only 0.5 percent higher than it expected pre-budget, which would seem to imply that growth from 2023 to 2025 will actually be lower than it would have been without the budget measures. 

As for the fiscal impact, the PBO estimates that the cumulative deficit for fiscal years 2021 to 2025/26 will be C$ 117 billion higher as a result of the budget measures. Its base case estimate is that the deficit will be C$ 36 billion in FY 2025/26, with a debt-to-GDP ratio of 49.2 percent. This is broadly in line with the Government's own projections, but the PBO's sensitivity analysis is interesting. It sees a 35 percent probability that the debt/GDP ratio will be higher in FY 2025/26 than it is now (51.3 percent). Unsurprisingly, it sees only a 5 percent probability that the budget will be balanced or in surplus by FY 2025/26 -- which looks quite frankly like a very optimistic figure. 

Part of the uncertainty in the PBO's projections arises from the likely response of financial markets to the forecast deficits and inflation. As the report states, Monetary policy responds to the increase in economic activity and inflationary pressures, raising the policy interest rate by 50 basis points in the second half of 2022 relative to our pre-budget outlook.

The Bank of Canada remains committed to keeping monetary policy accommodative until the end of next year, but the PBO appears to be suggesting that this will not be possible. Recent developments in bond markets have shown that investors may even less patient, particularly if the current uptick in inflation proves more durable than the Bank expects. If official rates continue to rise in 2023 and beyond, bond yields are likely to increase further,  raising government spending, reducing revenues and offsetting the stimulus that the fiscal measures are intended to provide.

The same can of course, be said of the United States. Like the Bank of Canada, the Fed intends to keep rates low in order to support the economy's recovery from the pandemic, but financial markets may have other ideas. President Biden's extravagant infrastructure proposals seems to be "too much, too late" in terms of their stimulative impact on the economy.  If the measures are passed on the scale that the White House is demanding, fiscal policy may well trigger an offsetting monetary policy response sooner rather than later. 

Things that make the Bank of Canada go "hmmm"

The uptick in inflation reported this week (see previous post) is one of the things the Bank of Canada is worried about at the moment, but it's nowhere near the top of the list. On Thursday the Bank released its Financial System review. Introducing the report to the media, Governor Tiff Macklem listed the Bank's key concerns as investors' rising appetite for risk, high home prices and indebtedness, climate-related vulnerabilities, fixed income market liquidity and the risks of a cyber attack on the financial system.

Regarding risk appetite, Macklem noted that  A rapid change in market sentiment—perhaps due to a setback in efforts to end the pandemic or a stalled economic recovery—could cause a sharp repricing of risk and a tightening of global financial conditions....Wider credit spreads could particularly affect Canadian companies that rely on high-yield debt markets.

As for the housing market and debt, the Bank's view can be summarized as follows:

Consumer preference, combined with low interest rates that make borrowing more affordable, has boosted demand for single-family homes, particularly in suburbs and outlying areas of major Canadian cities. Housing supply has not been able to keep up with this surge in demand, and this has pushed prices for single-family homes sharply higher in several markets.

...some households have taken on significantly more mortgage debt. The increased issuance of mortgages with high loan-to-income ratios is of most concern.... It is important to understand that the recent rapid increases in home prices are not normal. Even without a shock, some of the factors that caused prices to rise fast could reverse later, and that could leave some households with less equity in their homes. And interest rates are unusually low. Borrowers and lenders both have roles in ensuring that households can still afford to service their debt at higher rates. 

Not long after Macklem's speech, the Office of the Superintendent of Financial Institutions (OSFI) raised the "minimum qualifying rate" for new uninsured mortgages by 50 basis points to 5.25 percent. Borrowers must be able to demonstrate that they could still service their loans if rates rose to this level. Given that five-year fixed rate loans have been available this year for 1.7 percent or even less, this is a reasonably stringent test. 

On climate-related vulnerabilities, Macklem stated that The potential impact of climate risks is generally underappreciated, and they are not well priced. That means the transition to a low-carbon economy could leave some investors and financial institutions exposed to large losses in the future....in some parts of the country, particularly British Columbia and Ontario, households that are highly leveraged are also more exposed to severe weather events. The Bank....is also working to assess the financial-system implications of different scenarios for the transition to a low-carbon economy. We’re learning a lot from this work and will publish a report later this year.

On fixed income market liquidity, Macklem commented that While financial markets are currently functioning well, the extreme market stresses that occurred when the pandemic struck highlighted the vulnerability of the financial system to sudden spikes in the demand for liquidity. Over the past decade, the potential demand from the asset-management industry for market liquidity in periods of stress has outpaced the capacity of banks to provide it. We are working at both domestic and international levels to better understand this structural liquidity vulnerability and how best to improve the resilience of core funding markets.

And last but not least on the risk of cyber attacks, the digital transformation of the economy and the interconnected nature of the financial system—globally and in Canada—increase the risks of a cyber attack. The recent ransomware attack on a top US pipeline operator is a timely illustration. This FSR discusses a number of cyber security initiatives the Bank is leading.

It's a long and varied list, so it's perhaps worth concluding with Macklem's customary words of comfort regarding the Canadian financial system:

The Canadian financial system went into this crisis in a solid position and has proved to be resilient. This reflects sound risk management across a range of financial system participants combined with Canada’s strong regulatory and supervisory framework. Unprecedented policy support from governments and the Bank has also played a crucial role. Together, these factors have allowed the financial system not only to weather the huge shock but also to act as a shock absorber for the broader economy—by continuing to provide credit and by deferring loan payments for some households and businesses.

Here's hoping he's right. 

Price pressures in Canada

As in the United States, so also in Canada. Last week the BLS reported that US headline CPI jumped 4.2 percent year-on-year in April.  It blamed much of the increase on the "base effect" created by the fall in prices at the start of the COVID pandemic a year ago.  This morning Statistics Canada reported that Canada's headline CPI rose 3.4 percent year-on-year in April, up from 2.2 percent in March. It too blamed the base effect for much of the increase, but as in the US, there is more to the story than that, and it may soon have implications for monetary policy.  Every sub-component of the index was higher on an annual basis, suggesting the possible emergence of broad-based price pressures. 

The unexpectedly large increase in headline CPI on a year-on-year basis was heavily influenced by gasoline prices, which rose a startling 62.5 percent, the largest increase ever measured by StatsCan. This was partly a base effect, as gasoline usage (and hence prices) fell sharply at the start of the pandemic. It also reflected the introduction of higher carbon pricing by the Federal government over the course of the year, with the most recent increase coming at the start of April.  Excluding gasoline, the yearly rise on CPI was 1.9 percent, while the core index (excluding food and energy) rose 1.8 percent.

The lower increase in these special aggregates should be of only limited comfort to policymakers, because the data for the month of April itself have some worrying elements.  The month-to-month increase in headline CPI for April was 0.5 percent (unadjusted) or 0.6 percent (seasonally adjusted). These monthly figures annualize to a rate of 6-7 percent, well above the Bank of Canada's 2 percent central target. In addition, all three of the Bank of Canada's preferred measures of inflation rose in the month, with two of the three now standing at 2.3 percent year-on-year. 

Like the Federal Reserve, the Bank of Canada has explicitly stated that it will "look through" any temporary spike in inflation, such as that created by the base effects. Both institutions have said they will allow inflation to move above target temporarily as they endeavour to support the economic recovery from the COVID pandemic. At the same time, both wish to keep inflation expectations well-anchored at 2 percent. The base effects will fall out of the year-on-year calculation in both countries in May, but the key factor to look at when the next CPI data appear will be the monthly increase rather than the yearly change. In the case of Canada, a monthly rise anywhere close to the April figure will certainly boost expectations that rates will start to rise sooner than the Bank of Canada has been signalling.   

What does the Fed do now?

US consumer inflation data for April, released today by the Bureau of Labor Statistics, came as a nasty surprise, and markets have reacted badly.  Headline CPI rose 4.2 percent year-on-year, far above  market expectations for a 3.6 percent gain and marking the largest yearly increase since September 2008. There is a strong "base effect" at work here, thanks to the sharp fall in price pressures a year ago at the height of the first wave of COVID, but the data for April itself -- a 0.8 percent month-on-month gain -- also exceeded expectations.

The details of the report are not comforting. Core CPI rose 0.9 percent in the month, the biggest gain in almost four decades, bringing the year-on-year change in that index to 3.0 percent. Prices within sectors of the economy that are now reopening as the pandemic retreats -- lodging, air travel, recreation -- all contributed to the monthly increase. Somewhat oddly, the biggest single contributor to the gain was a 10 percent increase in used car prices, which now stand fully 21 percent higher than a year ago.

Fixed income markets have been fretting about a rise in inflation for some time now. Today's data reflect a combination of reviving consumer demand as the economy reopens and supply chains struggling to catch up. Little relief is in sight in the near term, not least with the closure of the Colonial Pipeline leading to higher average gasoline prices across the country, which will be reflected in the May CPI data.

The implications here are significant for both monetary and fiscal policy.  The Fed has made it clear that it will tolerate a spell of inflation above its long-term 2 percent goal in order to keep the post-COVID recovery on track.  Still, it must be surprised and concerned that CPI has moved above the target so far and so soon. It wishes to keep inflation expectations anchored at the 2 percent level for the longer term, so it will have to assess how long consumers and investors will tolerate data like today's without starting to anticipate persistent price pressures. No change in either policy or rhetoric is likely any time soon, but the timetable for eventual tightening has undoubtedly shortened. 

As for fiscal policy, the strong GDP growth data for Q1 and today's evidence of rising price pressures will undoubtedly embolden the voices in Washington speaking out against President Biden's planned stimulus measures. Reports of record-high job vacancies across the economy indicate that it will be difficult for supply chains to react quickly to rising demand. That implies further supply-side price pressures and only adds credence to the Republican argument that generous benefit programs are deterring people from returning to the workforce. Even though that argument is largely without merit, the case for massive fiscal stimulus is becoming steadily harder to see. 

April jobs reports: the bad and the badder

Both the United States and Canada reported their employment data for April this morning. In both cases the numbers were worse than expected, but it's the US report that's raising the most eyebrows, even though the economy added more than 260,000 jobs in the month. Let's take a look, starting with the US.

There's an oft-repeated saying in financial markets" "buy the rumour, sell the fact".  For major economic indicators like the monthly non-farm payrolls reports, this means that traders position their books based on what the numbers (referred to in the trade as "the print") are expected to be. If "the print" is way off expectations, all hell breaks loose within minutes of the announcement.

Today's non-farms data were a very long way off expectations. The expert consensus, basing itself on both anecdotal evidence and previously-released data, such as the continuing fall in weekly jobless claims, was confidently calling for the addition of about a million new jobs in April. The actual figure was 266,000, which meant that the unemployment rate ticked up to 6.1 percent rather than edging lower as everyone had expected.

Post mortems and recriminations have been coming thick and fast ever since the data dropped. Perhaps the most succinct comment came from none other than Paul Krugman on Twitter: "Everyone agrees about the meaning of the unexpectedly weak jobs report: it says that what they were saying before, whatever it was, has been completely vindicated". Indeed so. If you are in the Biden camp, the numbers prove the need for continuing fiscal policy support for the economy, and President Biden has already taken to the media to say just that. For the Republican side, the details of the data suggest that the generous income support now being provided to households is encouraging people to stay home rather than return to work.

The best exegesis of the full report might be this article from Jordan Weissmann at Slate. In summary, he argues that the jobs reports are erratic and frequently subject to major revision, so this report may just be a fluke. He also notes that in the details of the data you can find support both for the view that generous benefits are keeping people on their couches (the Republican view) and that workers are still coming back into the workforce in droves (the number of people looking for jobs exceeded the number of new jobs created, which is why the unemployment rate ticked higher). His conclusion: "there’d also be no serious harm if policymakers just waited another month to see if hiring bounces back in May before making any rash decisions about curtailing unemployment benefits".  Given that 266,000 new jobs would be considered more than acceptable in more normal times, that looks like good advice.

Turning to Canada, we find that the economy lost 207,000 jobs in April, a worse outcome than the analysts' consensus for a loss of 175,000. The unemployment rate rose to 8.1 percent from 7.5 percent in March.  This report is much less surprising than that for the US. Two of the most populous Provinces, Ontario and British Columbia, imposed strict lockdown measures early in the month and it was those two Provinces that recorded the sharpest job losses, at 153,000 and 43,000 respectively. As has been the case since the start of the pandemic, the worst job losses were felt in industries most affected by public health restrictions, especially accommodation and food services and retail trade.  

The April data mark a significant setback in the gradual improvement in Canada's job market since the first wave of the pandemic, and leave the overall employment situation still below its pre-pandemic levels. Total hours worked in the economy fell by 2.7 percent in April and remain 3.9 percent below the peak set in February 2020.  Labour  force underutilization, the number of discouraged workers and the number of people working from home all also rose in April, indicating a general deterioration in labour market conditions in the month. 

An early return to an improving jobs market is not likely. COVID restrictions in Ontario are currently set to be lifted around May 20, which means they will still be in place when Statistics Canada carries out this month's survey. In any case, there are warnings from health professionals that the restrictions may have to stay in place for a few more weeks to ensure that the third wave is firmly quashed.  Lifting of restrictions may come in the early part of June, but today's data make it clear that the current quarter will see a decline in both overall employment and GDP for the first time since mid-2020.   

Dissecting the Canadian Federal Budget

Canada's independent Parliamentary Budget Officer (PBO) has just released its customary commentary on the recent Federal budget. The stated aim of the report is "to assist Parliamentarians in their budgetary deliberations", although it probably goes without saying that very few Opposition MPs have waited for this informed critique before unloading on the budget. 

In terms of the economic outlook for the budget's time horizon (out to fiscal 2025), there are no significant differences between the PBO's projections and those in the budget. (As usual, the budget projections for growth and inflation reflect the views of private sector economists). The PBO's forecasts for real growth are slightly slower than those in the budget, likely because the private sector economists made assumptions about additional fiscal stimulus in drawing up their projections. On the other hand the PBO's inflation forecast is slightly higher than that in the budget. As a result the nominal GDP forecasts,  arguably the key figure in projecting government revenues, wind up being very close. 

As for the fiscal outlook, the PBO projects that deficits will average about C$ 5.6 billion higher than the budget forecasts over the period to 2025. In the context of the forecast deficit for FY 2020/21 (already ended) of C$ 354 billion, or for 2021/22 of over C$ 150 billion, the discrepancies are not much more than rounding errors. They are, however, more significant in the "out years": for FY 2025/26, the PBO foresees a deficit of C$ 35.9 billion, against a budget projection of C$ 30.7 billion. The discrepancy is largely attributable to lower revenues in the PBO projections, reflecting shortfalls in both income tax revenues and income from Crown Corporations. 

The PBO report goes on to break down the additional stimulus spending in the budget. It notes that a significant portion of the "Recovery Plan" in the budget in fact represents the continuation of previously-existing COVID-related measures. It estimates actual new stimulus spending at about C$ 70 billion spread over three fiscal years, a much lower number than the budget claimed. That said, the PBO reiterates a concern it expressed pre-budget, that the stimulus may be misdirected. The stated goal in the budget is to restore labour market conditions to pre-pandemic levels, but in the PBO's judgment, the ongoing improvement in labour markets does not suggest this is the appropriate yardstick for determining the need for stimulus.  

Lastly, the PBO looks at the government's chosen "fiscal anchor", the debt-to-GDP ratio. While noting that the budget projects a slight fall in that ratio starting in FY 2025/26, the PBO notes that in the absence of the new measures in the budget, the ratio would have been 5 percentage points lower in that year, at 44.2 percent, than the government now projects.  Taking this together with the ultra long-term projections in the budget, which showed the debt-to-GDP ratio staying above its pre-pandemic level all the way to 2055,  the report concludes "the Government has decided to effectively stabilize the federal debt ratio at a higher level, potentially exhausting its fiscal room over the medium- and long-term."

This is, of course, the very point that the opposition Tories have been hammering away at since the budget was tabled. It may well turn out to be true, but we have still not heard very much from those same Tories about how they would have steered the economy through the pandemic without getting into exactly the same fiscal position.