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  • KPB & Co Research

Summary

This year has been unusually busy for Canadian policymakers as they face-up to the extraordinary challenge of keeping the economy moving in the midst of a global pandemic. In the past week, the Trudeau led government was even busier designing ways to take the "crutches off" the Canadian economy going into Q3-2020. The federal government has to find a delicate balance between slowly removing economic support and keeping the engines running at full speed. Fortunately, for the federal government, the Bank of Canada ( BoC ) is busy fostering an environment of massive liquidity and low rates. The highly liquid environment is critical for many reasons, but perhaps most important is the fact that it provides the government with room to  pay off debt.

BoC's Policy Stance

Today - July 15, 2020 - the BoC announced that they are maintaining the target for the overnight rate at 0.25%, the Bank Rate at 0.50%, and the deposit rate at 0.25%. In addition to keeping policy rates low, the Bank also committed to maintain quantitative easing (QE), which encompasses the weekly purchases of C$5Bn in Government of Canada (GoC)  Bonds, the purchase of corporate bonds, and the implementation of short-term liquidity measures such as SWAPs. Going forward, the Bank expects to keep monetary conditions highly liquid until there is evidence that its inflation target of 2% is within reach. The Bank's core measure of inflation is currently running between 1.4% and 1.9%, but the CPI inflation is near zero.

By all indications, economic growth in the upcoming quarters will be soft in-spite of the gradual re-opening of the economy. In the Bank's baseline scenario, there is a solid recovery in economic activity in Q3, and a tapering off of the recovery speed as Q4 approaches. By year-end, the Bank anticipates that persistent weak consumer confidence will see GDP decline by 7.8% for the year, and the economic slack widens even as the supply conditions improve. Persistent slack in the economy is expected to hold prices back for a protracted period. In 2021, growth is expected to bounce back to +5.1%, but then drop to +3.7% by 2022.  ​

Assisting The Feds

In the recently published fiscal snapshot, Bill Morneau outlined that the federal government will still borrow US$342.2Bn to support the economy despite cutting back on the level of support. In this context, the economic environment has to remain highly stimulative for economic activity, while keeping interest cost low for the biggest borrower in the market - the federal government. Economic conditions also have to facilitate heavy company borrowing and government borrowing at the same time while muting the crowding-out effect - where government out-compete firms for capital. In anticipation of tough economic conditions, the federal government is boosting support to firms, while gradually reducing direct assistance to households. The government is expected to expand wage subsidy support to C$82.3Bn. To date, the wage subsidy programme disbursed C$18.0Bn to companies. At the same time, the Canada Emergency Response Benefit paid out C$54.8Bn and the budget remained at C$80Bn. The risk with relying more on firms to carry the load is that firms will cut jobs rather than rely on government support to keep themselves afloat, thereby leading to depressed consumer demand. As such, the Bank's strategy to keep monetary conditions highly liquid is necessary to offset the challenges that will surface as the crutches are removed.

​Concluding

Expectedly, the BoC kept policy rates near zero, and quantitative easing running at full speed. Though many capital market participants may argue that this will make companies heavily reliant on unsustainably low rates, ​monetary and fiscal authorities have very little options to prevent a full-blown crisis. Going forward, the government is looking to cut down on support to keep federal debt levels manageable. This situation risks the economy falling off a cliff should consumer demand remain challenged. In this context, keeping financial markets highly liquid through a combination of quantitative easing and low policy rates is necessary to keep the ship afloat.


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