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.