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.