By Ken White
GLOBE-Net, April 20, 2021 – Over the past year, the COVID 19 pandemic has caused considerable havoc to the world economy, including Canada. To avoid economic collapse and an unprecedented decline in the nation’s output and employment, the Bank of Canada is growing the money supply and holding target interest rates at record lows (0.25%).
The federal government and the provinces are engaging in massive fiscal expenditures and incurring record levels of debt to buoy up the economy and stop an economic catastrophize from happening.
These extraordinary measures have stopped the economy from falling off a cliff.
After a sharp decline in the second quarter of 2020, employment (based on actual hours worked) has almost caught up to pre-pandemic levels. The construction industry has benefited from the free-flowing and cheap money and government emergency transfer payments are keeping households afloat.
However, it’s been a bumpy ride.
At issue here is whether the Bank of Canada’s expansive monetary policies are adequate to the challenges ahead beyond the immediate needs of the pandemic. There are limits to how much the Bank of Canada can print money and the leverage it has to influence financial markets.
Simply put, is the Bank of Canada broke or broken?
In March 2020, a couple of months into the pandemic, commercial credit was seriously limited, and investors began converting assets to cash, which constrained available credit even more.
The Bank of Canada, at this point, decided that decisive intervention was needed, especially as the adverse effects of the pandemic were taking hold. Greater liquidity (more money at cheap interest rates) was urgently needed. It subsequently purchased unheard-of amounts of treasury bills, government bonds, and other securities to provide more cash for the sellers of these assets.
The Bank of Canada grew its financial assets from $120 billion in March 2020 to $525 billion by early April 2021.
Over 60% of these assets are in Treasury Bills and Government of Canada bonds. Thirty-one percent are in securities purchased under resale agreements, and the remainder in Canada mortgage bonds, provincial bonds, and corporate assets.
The fiscal stimulus helped stabilize the economy, and the plethora of new low-interest mortgages kicked started the housing sector for both new residential construction and resale of homes. The new money enabled governments to assist thousands of people who lost their jobs from the pandemic. Banks and trust companies issued mortgages and housing lines of credit.
The impact on price stability from this growth in the money supply has been mixed.
The Consumer Price Index (CPI) remained well within the Bank of Canada 1% to 3% threshold in 2020-21. From February 2020 to February 2021, core inflation tabulated for the Bank of Canada rose by only 1.5%. Both inflation and deflation were coinciding.
Slowing inflation was due to pandemic restrictions and physical distancing, reflecting how Canadians adapt to staying home and travelling less.
While the CPI growth has been slow, various industrial component costs and building construction prices have been soaring. Year over year, from March 2020 to March 2021, producer prices increased 9.4%.
Over this period, lumber and other wood products increased by 68.2%. Primary non-ferrous metal products grew by 29.3%. Chemicals and chemical products grew by 10.1%. Fabricated metal products and construction materials rose by 8.6%.
These rising industrial prices were caused by robust housing construction and reselling activity tied to cheap mortgages. The February composite housing price index by Teranet and the National Bank of Canada was up 9.8% from a year earlier as of February 2021.
The availability of cheap money tends to create asset bubbles. Evidence of this is already emerging in hyper-active stock market activity and, of course, in overheated housing markets.
The TSX composite fell sharply to 12,648 in late March 2020 and rebounded steadily to its mid-April level of 19,158. This intense growth period coincided with the Bank of Canada’s major asset purchases.
Budget 2021 stated that the federal market debt is $1,079 billion in 2020-21 or almost half of GDP. In 2021-22 it is estimated and to be $1,233 billion or 51.2% of GDP. The federal deficit for 2020-21 is $354.2 billion or 16.1% of GDP.
The Budget proposes $135 billion in new spending over the next five fiscal years. Debt servicing costs are estimated to remain at near-historic lows (1.4 percent of GDP in 2025-2026, compared to 5.8 percent in 1992-1993).
The Budget argued that “Notwithstanding the sharp increase in the federal debt-to-GDP ratio, public debt charges are projected to remain historically low. Despite recent increases in interest rates in Canada and elsewhere due to a stronger and faster-than-expected recovery, public debt charges as a percent of GDP are expected to stay near their lowest level in over a century over the forecast horizon.”
An unexpected rise in interest rates or another economic shock would pose serious financial consequences to the federal optimism of continuing low public debt charges.
The fiscal pinch is not limited to the federal government. All provinces and many large cities are also feeling the pain, and most have put their deficit-reduction plans on hold and are demanding more outstanding direct federal financial support.
The fiscal policies primarily involved transfers of money to workers, renters, students, and businesses to ease the negative impacts of the pandemic. Many households saved rather than spent this money. Canadian dollar deposits in personal accounts grow from $311 billion in January 2020 to $427 billion in January 2021.
Canada’s fiscal and debt balancing act is in line with some of our key trading partners. The International Monetary Fund (IMF) reports that Canada’s deficit was 12.7% of GDP in 2020 and is projected to be 7.8% in 2021. In comparison, the deficit to GDP ratios of 10.8% in 2020 and 10.4% in 2021 for advanced economies. The United States and the United Kingdom show higher deficit to GDP ratios in 2021 (15.0% and 11.8%, respectively).
Faced with high levels of debt, extreme difficulties in implementing austerity programs, and new taxation, Canada, like other developed governments, faces a tricky balancing act where traditional fiscal and monetary measures are much less effective in preventing economic chaos.
This balancing act entails a mixture of policy tools, including building excellence in debt issuance and management, unlocking the funding potential of balance sheets, optimizing revenue streams, and containing expenditures. These are exceedingly tricky trade-offs.
Limits of Monetary Policy
The COVID-19 crisis is unlike anything Canada and the World have faced in recent years. Events in the business cycle triggered other downturns. Today, many businesses are shutting down to protect workers and consumers from the virus.
Monetary policy tools do not lend themselves well to such extraordinary circumstances. Fiscal tools are more effective in dealing with supply constraints and forced unemployment.
The massive asset purchases by central banks from developed economies were essentially an experiment in employing an unconventional tool that governments believed was urgently needed to provide desperately needed credit to governments, institutions, and corporations to keep the economy operating.
The longer-term impact on both inflation and the stability of the Canadian dollar, however, is uncertain.
The Bank of Canada inflation-targeting regime of 1% to 3% comes up for renewal later in 2021. The CD Howe Institute in a recent report argued that this inflation targeting regime should not be overhauled as it has served Canada well. Relaxing these inflation targets to allow inflation to exceed these targets could forestall a return to a higher policy rate. Consumers would pay higher prices, but governments would keep its low debt servicing costs.
When there is a run on the Canadian dollar tied to the deficit and debt, the Bank of Canada raises interest rates typically to encourage an inflow of foreign capital and buoy up the dollar. However, the adverse impact this would have on governments’ debt servicing costs would seriously tie the central Bank’s hands.
The Bank of Canada is under enormous pressure to keep this activity up. There are many moving parts to this economic recovery, and longer-term serious risks are involved. These risks include inflation (after the pandemic has moderated), the creation of asset bubbles, including housing prices, and a potential run on the Canadian dollar, which could occur if Canada’s fiscal anchors become more distorted than other advanced economies.
The role of monetary and fiscal policy is blurred when purchasing large amounts of government debt at almost zero interest rates is financed by money creation by the Central Bank.
Broke or Broken?
The Bank of Canada is in a hard place now. If future inflation or a run on the dollar necessitates higher interest rates, federal and provincial governments carrying massive low-interest debt will suffer from higher borrowing costs, which may involve insolvency risks and credit downgrades.
The Bank generally operates independently of governments, but the current high fiscal debt makes this problematic. Theoretically, the Bank could never be ‘broke’ simply because of its capacity to print money. However, some of the tools available to it are broken or ineffective in the face of what lies ahead.
Due to the high levels of debt and fiscal imbalances, the federal government needs interest rates to remain near zero if it continues to use budgetary stimuli to recover from the pandemic and grow the economy beyond 2020-21.
The pressure is on the Bank of Canada to use its policy tools to keep interest rates low and continually expand the money supply to facilitate the recovery. However, as stated, these policy tools, especially significant purchases of government and corporate debt, carry enormous longer-term risks, and caution is needed.
Ken White is a semi-retired economist living in Port Coquitlam, British Columbia. His recent work has been modelling the economic impacts of the green economy in British Columbia and other provinces. Previously when working for the Federal Government in Ottawa, Ken worked extensively with its financial management system and the federal Main Estimates. Ken maintains a strong interest in fiscal and monetary policies and issues.