Fiscal spending the only way out for Canada’s struggling economy?

October 29, 2015

Liberal Party leader Justin Trudeau waves while accompanied by his wife Sophie Gregoire as he gives his victory speech after Canada's federal election in MontrealAfter sailing relatively smoothly through the choppy waters of the financial crisis and its after-effects, the Canadian economy is finally getting caught up in the global economic slowdown.

Canada’s traditional growth drivers now seem in a rut and there is no respite in sight.

Oil, a major Canadian export, has lost more than half of its value since July 2014 and is not expected to rebound anytime soon. Low interest rates have fueled a big rise in household debt and the housing market is at risk of a correction.

Now Canada’s new Prime Minister, Justin Trudeau, wants to bring fiscal policy to the forefront by focusing on infrastructure spending.

He has proposed running an annual budget deficit of up to C$10 billion ($7.63 billion) for three years to invest in infrastructure and boost economic growth.

A recent Reuters snap survey showed economists were more likely to revise their growth forecasts higher as a result.

According to Bank of America Merrill Lynch’s estimate, stronger government infrastructure spending could add 0.1-0.3 and 0.1-0.5 percentage points of upside risk to growth in 2016 and 2017 respectively.

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But the Bank of Canada gave a rather pessimistic view of the economy, even as it escapes recession, at its policy meeting just following the election result.

Canada GDPWithout incorporating the new government’s fiscal plans into its outlook, it downgraded its growth projections for the fourth quarter to 1.5 percent from 2.5 percent and for 2016 as a whole to 2.0 percent from 2.3 percent previously.

A Reuters poll taken earlier forecast 2.5 percent growth in third quarter and 1.7 percent growth in the fourth.

Nonetheless, Governor Stephen Poloz held onto his optimism of an economic recovery led by stronger U.S. demand and a weaker Canadian dollar, which he says will help boost exports.

But U.S. economic growth braked sharply in the third quarter to just 1.5 percent on a run-down of inventories, suggesting a U.S.-led recovery and an ensuing rise in inflation may be a big ask, particularly as the Bank has no control over U.S. demand and any support from a weaker currency may have already been at least partially priced in. The central bank will probably not be able to propel the economy much single-handedly.

It may also not want to waste ammunition after cutting rates two times this year to near-zero — moves that are yet to yield tangible results.

Its other developed market peers are also struggling to get results from traditional monetary policy tools.

In the euro zone, depressed prices have fueled debates of negative deposit rates, even as erstwhile monetary policy initiatives prove largely ineffective.

Even Sweden’s central bank has had negative interest rates for nearly 10 months now, with a bond purchase programme, and said it would cut rates even more if needed. Inflation has barely budged during the same period.

Quantitative easing so far has failed to help the Bank of Japan hit its inflation target, too, even after a decade and a half of purchases. It is expected to trim already weak inflation forecasts at its meeting on Friday.

So fiscal policy, economists say, might be the only option left to usher in any meaningful recovery in Canada.

David Madani, economist at Capital Economics said:

From 2011 to 2015, fiscal policy was acting as a significant brake on the economy for a long time.

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The fiscal-monetary policy mix needs to change, with fiscal policy becoming more active. Considering the excess capacity in the economy and uncertain economic outlook due to low oil prices, housing imbalances and slow growth abroad, we are less concerned about the typical timing objections often put forward as a reason for fiscal policy to remain passive during economic.

Canada has already experienced one of its slowest periods of growth in recent decades, punctuated by the global financial crisis and an unforeseen recession in the first half of this year following the oil price plunge.

Economists in the Reuters poll also said if Trudeau’s proposal materializes – most likely by mid-to-late 2016 – it could trim potential downside risks to the Bank’s growth outlook, allowing it to keep rates unchanged until 2017.

However, much depends on how the untested leader implements his policies and puts the economy back on track.

Otherwise, Canada might just have to deal with the same problems all of its trade partners are currently grappling with.

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