BoC can’t afford to delay normalization: report

When the Canadian economy was suffering from the effects of the 2015 oil shock, and after the BoC cut interest rates that were already low, it became clear that the economic policy mix was unbalanced, notes a report by Desjardins.

It was time for more expansionary fiscal policy, writes Jimmy Jean, senior economist at Desjardins. During the 2015 federal election campaign, the Liberals made such a commitment. In its spring 2016 budget, the government announced $120 billion in total infrastructure projects over a 10-year period. An additional $81 billion was announced in the fall update.

Read: Monetary policy to be data dependent: BoC

“The government is now approaching the middle of its mandate, and while some fiscal interventions have paid off (notably the family tax credits), the economic impact of the public infrastructure component is widely regarded as a disappointment to date,” notes Jean. “This is a crucial component of fiscal policy. Infrastructure spending has higher multiplier effects than tax relief for households. It also helps boost productivity growth, thus ensuring long-term gains.”

But there are signs that indicate the beginning of a more substantial effect, he adds.

“True, the national accounts revealed an anemic annualized growth rate of 0.5% in government fixed capital formation for Q2, hardly contributing to GDP growth. However, part of the weakness is due to an annualized decline of 4.1% in public investment in non-residential buildings, as well as a 1.0% contraction in investment in intellectual property.”

Read: ‘Epic fail’ distracts investors from key BoC policy initiative

These declines, notes Jean, masked a robust 14.7% expansion in engineering works, the component most directly related to public transit infrastructure projects.

“And this might only be the beginning,” he writes. “According to Infrastructure Canada, 60% of the first public transit investment fund remains to be allocated, mainly in Quebec and Ontario.”

Even while the Canadian economy hovers near its full capacity, the full effect of announced infrastructure investments has yet to be felt, notes the report. It speaks to the main shortcoming of fiscal policy: its slowness.

Read: Expect ‘significant’ increase in bond yields: economist

“There are implications that can be drawn for monetary policy,” adds Jean. “The risk is that the Canadian economy is over-stimulated, which would in principle lead to upward pressure on inflation and force the BoC to tighten its monetary policy more rapidly. With the high debt load of Canadian households, an abrupt tightening would not be the ideal scenario.”

He adds, “This is why, despite the uncertainty that prevails on several issues, the BoC cannot afford too much delay in its normalization. Rather, the BoC would be better off signaling that, apart from a major negative shock, it will continue to reduce the degree of monetary accommodation in gradual fashion.”

Read the full report here.