This past week brought many new developments related to the future of Canadian monetary policy and its relationship with fiscal policy in the post-coronavirus era. First, Finance Minister Bill Morneau announced on Friday that Tiff Macklem would begin his seven-year term as the next Governor of the Bank of Canada (BoC) after current Governor Stephen Poloz steps down on June 1. Macklem, currently the Dean of the Rotman School of Management at the University of Toronto, was previously senior deputy governor of the Bank of Canada under Governor Mark Carney and recently chaired the government’s Expert Panel on Sustainable Finance, which published its final report in 2019.
Second, the Parliamentary Budget Officer (PBO) updated its Covid-19 scenario analysis last week and now projects the federal budget deficit to rise to C$252 billion (12.7% of GDP) for the 2020-21 fiscal period. As a share of the economy, the 2020-21 budgetary deficit is expected to be the largest on record. The PBO’s macroeconomic scenario assumes a 12% decline in Canadian GDP in 2020, and a US$16/barrel average price for West Canada Select oil prices in 2020, well below profitable levels for Canadian energy companies. The 2020-21 budget deficit worsens in two parts from the prior C$184 billion estimate in early April: C$27 billion from automatic stabilizers and a worsening economy and C$40.5 billion additional spending for a total of C$146 billion in Covid-19 relief (see the chart below). This brings Canada’s fiscal spending to 7.3% of estimated 2020 GDP.
Without central bank purchases and near-zero policy rates, the growing federal indebtedness would almost certainly imply higher interest rates. The next governor of the Bank of Canada will have to carefully modulate its bond purchases to ensure that financial conditions remain consistent with the central bank’s goal of ensuring price stability. Already since March when the BoC announced special policy measures in reaction to the coronavirus to improve market functioning and liquidity, total assets on the BoC’s balance sheet have grown from C$120 billion to over C$380 billion, principally owing to its buying of treasury bills, Government of Canada securities and conducting overnight and term repo operations (see the chart below).
We assume the BoC will finance the growing federal deficits by purchasing much of the new Government of Canada bond issuance to limit the backup in interest rates and an unwanted tightening of financial conditions. At the current pace of C$7-8 billion per week, this would mean the BoC would own Government of Canada bonds equivalent to 15-17% of GDP by March 2021. Assuming a steep decline in economic output to begin 2020 as well as a slow recovery for the energy sector and household consumption over subsequent quarters (see the chart below), deficits may have further to rise. But even if they did, this would likely imply even greater BoC bond purchases than the current trend.
In our view, central banks will likely be keen to limit interest rate increases after the coronavirus crisis passes while at the same time supporting a firming of inflation expectations. Amid sustained low nominal interest rates, these efforts would likely weigh on the real return of government bonds and raise questions about their strategic portfolio diversification benefits. For more on our strategic case for reduced long-term holdings of nominal government bonds, please see our global weekly commentary.
Kurt Reiman is a Managing Director and BlackRock’s Chief Investment Strategist for Canada. Kurt is a regular contributor to The Blog in Canada.
Daniel Donato is an Associate within BlackRock’s Toronto office.