MNI: Carney Deficits Are Bulwark Against Big Macklem BOC Cuts

A growing budget deficit under Prime Minister Mark Carney aimed at countering the hit to demand from the U.S. trade war means Bank of Canada Governor Tiff Macklem will not need to lower interest rates much further to support flagging growth, former officials told MNI. 

"Expansionary federal fiscal policy will likely be one of several factors that prevents the Bank of Canada from cutting interest rates into stimulative territory," said Tony Stillo, former forecasting manager at Ontario’s finance ministry. (See: MNI: Canada Approved CAD95B Geopolitical Contingency Borrowing)

The Bank is widely expected to cut its 2.75% policy rate 25bps Wednesday, while one more reduction in either October or December is also seen as a strong possibility. Two cuts would take the key rate to the bottom of the Bank's estimated neutral range, at a time when core prices are advancing at a 3% rate, another constraint on monetary stimulus.

Carney's pledge to trim program spending freeing up money to back investments in large resource projects is unlikely to keep the deficit in line on top of a pledge to boost military spending to NATO's target according to Stillo, now with Oxford Economics. Fiscal policy will boost GDP 0.2pp next year and 0.7pp in 2027 according to Stillo, which is significant given a rate cut influences growth over two years.

DEFINITE INFLUENCE

Deficit spending will "definitely" influence the Bank's path even amid the hit from the U.S. trade war says Pedro Antunes, a former BOC economist in the domestic forecasting group and now chief economist at the Conference Board of Canada. (See: MNI INTERVIEW: Mild Stimulus Cures Canada Recession- Ex-Clerk)

"That weakness is already being felt but might be countered by policy measures the Carney government is putting into place," Antunes said. "Ultimately, the Bank will react to how inflation and the economy are progressing." While Canada's economy could rebound late this year from a tariff-related contraction, its trade deal with the United States is up for renegotiation next year and that could again scramble growth and inflation. 

Carney won an election at the end of April pledging to revitalize Canada's economy while running a deficit of CAD62 billion or 2% of GDP and a pledge to lower debt as a percentage of GDP over a four-year mandate. Officials tell MNI that fiscal "anchor" will be difficult with new spending commitments. The budget for the fiscal year that began April 1 will be presented in October after being delayed by the election and Parliament's summer recess.

This year's deficit will also rise because Carney dropped counter-tariffs that were to bring in billions of dollars and because plans to trim program spending by 15% are difficult to realize, officials told MNI. 

CARNEY'S STREET CRED

"With a high degree of uncertainty around the economic outlook and promises that very likely require hard tradeoffs just to keep debt as a share of GDP tilting in the right direction, this credibility will be key," said Rebekah Young, a former finance department and IMF official now at Scotiabank. 

"Carney’s government has clearly articulated Canadians can anticipate greater deficit spending ahead," Young said, and deficits could remain around 2% of GDP in coming years. Scotiabank sees two Bank of Canada cuts this year and earlier argued the Bank could hold the line for the rest of this year. 

Former finance department economist Dominque Lapointe agrees two cuts and fiscal action should pull Canada through the current weakness. He also cautioned that another growth setback, even a big fiscal boost from Carney, won't be enough for Macklem to remain that cautious.

"If the choice is between we have to cut to support jobs, it’s the only way we can, and the government is spending more and maybe it provides a floor... it’s not going to be enough,” said Lapointe, now macro strategy director at Manulife Investment Management.