The Canadian federal government released its 2023 budget over a year ago, promising to conduct a strategic spending review to find $15.4 billion in savings. The savings were supposed to achieve fiscal credibility by offsetting the $43 billion in new government spending. However, nearly a year after its announcement, the spending review found only $9 billion in savings, while the government piles on new spending measures in this year’s budget.

The fiscal path is mostly the same as in the 2023 Fall Economic Statement, but only after revenue gains from a resilient economy and further tax increases triggered even bigger spending initiatives.

Government spending is expected to be $480 billion in the next fiscal year, including $54 billion in payments on the country’s debt.

Finance Minister Freeland also announced a soak-the-rich tax scheme, levelling higher taxes on capital gains for people who make more than $250,000 selling stock or property other than a person’s primary residence.

Currently, 50% of capital gains profits are taxed, compared to 100% of a person’s employment income. That will remain the case for the first $250,000 of capital gains income, but it will rise to 66.6% on income above that level. So, the proposal is to reduce the tax-exempt amount to one-third for capital gains exceeding $250,000.

The lower exemption would also apply to businesses for all capital gains, not just those over $250,000. The additional capital gains taxes are expected to rake $19.4 billion into the government’s coffers over the next five years, which is no small measure. This will reduce business capital spending, already at rock-bottom lows, rendering the Canadian productivity problem even more egregious. Higher capital gains taxes also disincentivize investment in residential rental real estate. 

The FY24/25 budget deficit is estimated at $39.8 billion (1.3% of GDP), with the numbers massaged just enough to meet the various ‘fiscal guideposts’. Any path to a balanced budget continues to be absent.

Bank of Canada Governor Tiff Macklem has said provincial government spending is already making it harder to lower inflation. Running federal deficits — on top of large provincial deficits in Quebec, Ontario and British Columbia — is irresponsible. The government had previously set fiscal anchors, like keeping the deficit below 1% of GDP starting in 2027.

Philip Cross of the National Post writes, ”deficit spending when inflation is above target violates the 1991 accord between the Government of Canada and the Bank of Canada, which “jointly set forth targets for reducing inflation” and requires both parties to collaborate to achieve that goal.”

Cumulatively, the total deficit between FY23/24 and FY28/29 is now running $10 billion larger than in the Fall Economic Statement.

The Housing Plan

The housing measures were pre-announced, and the market impact should be minimal. However, the higher capital gains inclusion rate will impact those planning to sell valuable properties with much lower cost bases. It will change the economics of real estate investment in rental properties, an area that needs to be more generously funded. 

Some Other Housing Measures:

Allowing 30-year mortgage amortizations for first-time home buyers purchasing new builds. This measure zeroes in on a small subset of the market. In general, though, it stokes excess demand and ultimately does little to improve affordability once prices adjust. Also, limits on the size of insured mortgages mitigate its impact in our most expensive cities. Pre-construction sales usually require a 20% downpayment, which limits the use of insured mortgages, which account for only 15% of mortgage originations.

Accelerated capital cost allowances on the construction of new purpose-built rentals and removal of the HST on the construction of student rentals.

Increase the annual Canada Mortgage bond limit to $60 billion from $40 billion.

Top up the Housing Accelerator Fund to incentivize the removal of zoning barriers and tie transit funding to densification along transit corridors.

This is a pre-election ‘tax and spend’ budget, which will do little to address the problems it claims to solve. It exacerbates other concerns, including insufficient business capital spending, low productivity growth, and insufficient investment in rental real estate.

Slowing the growth in nonpermanent immigration will, in time, do more to address the housing shortage than any of these measures.

Headline inflation of 2.9% marks the first time since June that inflation has moved into the Bank of Canada 1%-to-3% target band and only the second time to breach that band since March 2021.

Grocery price inflation also decelerated broadly in January to 3.4% y/y, down from 4.7% in December. Lower prices for airfares and travel tours also contributed to the headline deceleration. Prices for clothing and footwear were 1.3% lower than levels from a year ago, potentially reflecting the discounting of winter clothing after a milder-than-usual winter in much of the country.

The shelter component of inflation remains by far the largest contributor to annual inflation. The effect of past central bank rate hikes feeds into the CPI with a lag. The y/y growth in mortgage interest costs edged lower in January but still posted a 27.4% rise and accounted for about a quarter of the total annual inflation. Inflation, excluding mortgage costs, is now at 2.0%. Home rent prices continue to rise, but another component under shelter – homeowners’ replacement costs inched lower on slower house price growth.

On a monthly basis, the CPI was unchanged in January, following a 0.3% decline in December. On a seasonally adjusted monthly basis, the CPI fell 0.1% in January, the first decline since May 2020.

Notably, the share of the CPI basket of goods and services growing at more than 5% has declined from the peak of 68% in May 2022 to 28% in January 2024.

The next meeting of the Bank of Canada Governing Council is on March 6. While January’s inflation report was better than expected and shows that the breadth of inflation is narrowing, it is still well above the level consistent with the 2% inflation target.

Shelter inflation will remain sticky as higher mortgage rates over the course of last year filter into the index and the acute housing shortage boosts rents.

The Bank of Canada will remain cautious in the face of still-high wage gains and core inflation measures above 3%. I hold to my view that the Bank will begin cutting rates in June.

While inflation ended 2023 at 3.4%, owing mainly to high and sticky shelter costs, “the Bank expects inflation to remain close to 3% during the first half of this year before gradually easing, returning to the 2% target in 2025. While the slowdown in demand is reducing price pressures in a broader number of CPI components and corporate pricing behaviour continues to normalize, core measures of inflation are not showing sustained declines.”

The press release says that the “Governing Council wants to see further and sustained easing in core inflation and continues to focus on the balance between demand and supply in the economy, inflation expectations, wage growth, and corporate pricing behaviour.”  The Bank now believes the economy is in excess supply, inflation expectations and corporate pricing behaviour are moving in the right direction, and wage demands, at 5.4% year-over-year in the last reading–are still too high. Wages are a lagging indicator and with job vacancies returning to pre-pandemic levels, wage pressures are likely to dissipate as the year progresses.

The central bank focuses on “the balance between demand and supply in the economy, inflation expectations, wage growth, and corporate pricing behaviour” and remains resolute in restoring price stability.

Bottom Line

This was a more upbeat Bank of Canada statement. There is a good chance that monetary tightening has done its job, and inflation will trend downward in the coming months. As we have seen, the road to 2% inflation is bumpy, but we are heading there probably sooner than the Bank expects. As predicted, they are staying the course for now, but multiple rate cuts are likely this year. The scheduled dates for announcing the policy rate are March 6, April 10, June 5 and July 24. The Bank of Canada will begin cutting the overnight rate somewhere in there.

For now, my bet is on the June meeting, but if I’m wrong, it will likely be sooner rather than later. Once they begin to take rates down, they will do so gradually, 25 basis points at a time, and over a series of meetings. We could well see rates fall by 100-to-150 bps this year. Risks to the outlook remain, as always.

I do not expect the overnight policy rate to fall as low as the pre-Covid level of 1.75% this cycle. Inflation averaged less than 2% in the five years before COVID-19, depressed by increasing globalization and technological advances. Those forces are now reversed.

Employment in Canada rose by 24.9K in November 2023, following a 17.5K rise in October and above forecasts of 15K. Employment went up in manufacturing (+28K) and construction (+16K). On the other hand, there were declines in wholesale and retail trade (-27K) and finance, insurance, real estate, rental and leasing (-18K). November marks the fourth consecutive month of job gains. Still, the Bank of Canada noted in its October meeting that “recent job gains have been below labour force growth and job vacancies have continued to ease,” suggesting a slowdown in labour demand. The monthly employment gain averaged 39K so far this year, while monthly population growth has averaged 80.8K.

Rapid population growth–driven by Canada’s open-door policy–has boosted economic activity. Despite dramatic tightening by the Bank of Canada, labour markets remain resilient. While yesterday’s GDP release showed a 1.1% decline in growth in the third quarter, housing, government spending and private consumption added to growth. More recent data for Q4 suggest a pick-up in overall activity. Today’s employment data shows stronger-than-expected jobs gains in November.

In other data released last week, Canadian retail sales also surprised on the high side. Consumers splurged in September and October, a surprise resurgence in spending even as high interest rates restrict household budgets. Retail receipts rose 0.8% in October. That’s the biggest jump since April and followed an unexpected 0.6% increase in September, which far exceeded the median estimate of a flat reading in a Bloomberg survey of economists.

Employment declined by 27K (-0.9%) in wholesale and retail trade in November, adding to a drop of 22K (-0.7%) in October. As of November, employment in the industry was at its lowest since December 2022.

Employment in finance, insurance, real estate, rental and leasing fell by 18K (-1.3%) in November. Since July, employment in this industry has declined by 63K (-4.4%), the steepest decrease of any sector over the period.

Wage growth was steady at +4.8% y/y, still well above what the Bank of Canada targets, given the productivity decline.

On the soft side, hours worked fell 0.7% despite a significant rise in full-time employment. That’s the largest monthly drop since early 2022 and doesn’t bode well for GDP growth in the month after the surprise strength in October’s flash estimate released yesterday.

Last week, Governor Tiff Macklem said interest rates may be restrictive enough to restore price stability. He added that more downward pressure on inflation is in the pipeline, with the economy expected to remain weak for the next few quarters.

All the relevant data are in now for the Bank of Canada decision next Wednesday, December 6th. The Bank should maintain its pause and suggest that monetary easing may commence in the coming months depending on a continued decline in inflation. Right now, markets are forecasting the first rate cut in April 2024. That would certainly make for a robust spring housing market. I expect a 200 basis point drop in the overnight rate by the end of 2024 to 3.0%. This would imply a commensurate decline in VRMs. Fixed mortgage rates have already begun to drop owing to the sharp decline in mid-term bond yields. An acceleration in the drop in fixed mortgage rates is likely next year, as the spread between FMRs and market yields is still historically high.

Dr. Sherry Cooper
Chief Economist, Dominion Lending Centres

Employment changed little in October, up only 17,500 (0.1%), after rising 64,000 in September and 40,000 in August. The employment rate—the proportion of the working-age population with a job—fell 0.1 percentage points to 61.9% in October, as the population aged 15 and older increased by 85,000 (+0.3%).

As unemployment has increased and job vacancies have decreased in recent months, the labour force participation rate—the proportion of the population aged 15 and older that was either employed or looking for work—has remained relatively high. The participation rate in October (65.6%) was unchanged from the previous month and up 0.2 percentage points on a year-over-year basis.

Wage inflation continues to be troubling for the central bank. On a year-over-year basis, average hourly wages rose 4.8% in October, following an increase of 5.0% in September.

The Bank of Canada meets once again on December 6th. Before then, we will see another CPI inflation report on November 21, Q3 GDP on November 30 and the November Labour Force Survey on December 1. Given the Bank’s general reluctance to hike rates just before the holiday season, the Bank of Canada will remain on the sidelines.

Judging by today’s weaker-than-expected employment report in the US as well, the Fed will also hold their pause for the remainder of this year.

Rate relief, however, is still many months away. The central banks will want to see inflation at 2% with the belief that it will remain there before they begin to cut interest rates. That will happen, but probably not before next summer. According to Bloomberg News, “Traders in overnight swaps brought forward their expectations for when the Bank of Canada will start loosening policy, and are now betting policymakers will cut interest rates by 25 basis points in July, from September a day ago.”

Offsetting the deceleration in the all-items CPI was a year-over-year increase in gasoline prices, which rose faster in September (+7.5%) compared with August (+0.8%) due to a base-year effect. Excluding gasoline, the CPI rose 3.7% in September, following a 4.1% increase in August. Looking ahead to the October inflation report, the base effect for headline CPI is favourable, as CPI surged in October 2022. Gasoline prices are down about 7% so far this month. Given the war in the Middle East, however, there is no guarantee that this will hold, but if it does, the October headline CPI could move into the low-3% range.

On a monthly basis, the CPI fell 0.1% in September after a 0.4% gain in August. The monthly slowdown was mainly driven by lower month-over-month prices for gasoline (-1.3%) in September. Goods inflation fell 0.3% from a month earlier, the first time since December 2022, and grew 3.6% from a year ago versus 3.7% in August. Services inflation was unchanged from August, the first time it hasn’t grown on a monthly basis since November 2021, while the rate slowed to 3.9% on a yearly basis, from 4.3% in August.

Additionally, furniture prices (-4.6%) and household appliances (-2.3%) continued to decline year-over-year in September, contributing to the slowdown in durable goods. Consumers paid less on a year-over-year basis for air transportation (-21.1 %) in September, coinciding with a gradual increase in airline flights over the previous 12 months.

Other measures of core inflation followed by the Bank of Canada also decelerated.

Bottom Line

According to Bloomberg News calculations, “A three-month moving average of underlying price pressures that Governor Tiff Macklem has flagged as key to policymakers’ thinking fell to an annualized pace of 3.67%, from 4.29% a month earlier.”  While this is still well above the Bank’s 2% target, the global economy is slowing, the Canadian and US economies are slowing, and with any luck at all, the Bank of Canada might see inflation move to within its target range next year. However, the central bank will be cautious, refraining from rate cuts until the middle of next year. The full impact of rate hikes has yet to be felt. The next move by the Bank of Canada could be a rate cut, but not until next year.