Mission Concluding Statement 

Canada: Staff Concluding Statement of the 2023 Article IV Mission

June 20, 2023

Washington, DC:

The Canadian economy is gradually slowing toward potential and inflation is declining, although the still-strong labor market and renewed housing pressures underscore the importance of the Bank of Canada’s restrictive stance and of maintaining a data-dependent posture. Fiscal policy has been mildly contractionary, building on strong consolidation since 2020. Canada’s public debt is relatively low in international comparison, and to further enhance fiscal credibility, the government could consider adding to its commitment to medium-term debt reduction by adopting a quantitative fiscal framework. Meanwhile, financial regulation and supervision could be strengthened further by, inter alia, expanding stress testing of nonbanks and facilitating data sharing among federal and provincial authorities. Canada's actions to meet its climate commitments and to incentivize investment in green sectors are welcome, although the design of some incentives could pose some risks. Finally, measures to promote housing supply remain critical to address affordability concerns.

Recent developments, outlook and risks

The Canadian economy is gradually slowing but has been more resilient than expected. After slowing sharply in Q4:2022 (albeit partly reflecting a drawdown of inventories), activity accelerated in Q1:2023 on the back of strong trade and consumption, which offset weaker investment. The economy remains in excess demand for now, with the output gap estimated at +0.4 percent.

In line with these trends, labor markets are easing but remain tight. Vacancies have dropped noticeably and firms are reporting fewer labor bottlenecks and shortages, supported in part by a significant increase in immigration and in labor force participation, which may have been bolstered by the government’s investment in a Canada-wide early learning and childcare system. The unemployment rate, however, remains very low at 5.2 percent, and wage growth has been elevated.

Following a sharp correction, the housing market is now rebounding. While about half of the surge in house prices during the pandemic was erased during 2022, prices have risen again since the start of the year, while rents have climbed throughout. Stronger-than-anticipated housing prices and rents may reflect a combination of strong demand, fueled by the rapid post-pandemic increase in immigration, and reduced turnover from owners locked into cheaper mortgages.

Headline inflation has declined sharply from its mid-2022 peak, but core has been stickier. Headline inflation fell from a peak of 8.1 percent y/y in June 2022 to 4.4 percent in April, aided by substantial base effects related to energy prices. Declines in core inflation have been more moderate—from a peak of around 6 percent y/y last year to 4.1 percent in April—reflecting high services inflation, robust wage growth, and stubbornly high near-term inflation expectations. In fact, on a three-month annualized basis, the Bank of Canada’s (BoC’s) preferred measures of core inflation rose to 3.9 percent on average in April, from 3.6 percent in March.

The banking system has remained resilient in the face of recent global financial stress. The high degree of concentration, with the six largest banks accounting for 92 percent of total assets, implies that almost all of the system is subject to the most stringent regulation and supervision. Banks are well capitalized and liquid and have remained profitable. Funding sources are well diversified, amid robust deposit growth, and small and medium-sized banks (SMSBs) also have weathered recent turmoil reasonably well. Commercial real estate (CRE) as an asset class is performing better than in other countries—partly on account of strong immigration, which has supported the development of multi-unit dwellings—and the concentration of CRE exposures in SMSBs seen elsewhere is not present in Canada. Similarly, pension funds are generally less leveraged than in some other advanced economies, they do not engage heavily in liability driven investment strategies, and they have access to liquidity backstops.

Looking ahead, the economy should continue to cool and inflation should decline toward target on the back of prudent macroeconomic policies. Tight monetary policies are driving higher borrowing costs and tighter credit conditions and supporting a slowdown in activity. Real GDP growth is projected to fall from an average of 3.4 percent in 2022 to 1.7 percent this year, with the economy bottoming out by the third quarter. Unemployment is expected to rise gradually to slightly above its long-term level of 6 percent in 2024. Meanwhile, headline inflation should ease to around 3 percent by September, supported by continued moderation in commodity prices. Core should reach that level by early 2024, and inflation should return to the 2-percent target by end-2024.

Risks to the outlook are elevated, and the economy could slip into a mild recession should downside risks materialize. An abrupt slowdown in the rest of the world, perhaps related to banking turmoil, would have important negative spillovers to Canada. Inflation could prove stickier than anticipated, which would require additional monetary policy tightening that would further weigh on growth. Meanwhile, financial stability risks have risen—upcoming mortgage resets could weigh on household consumption and pose debt service challenges, although these are expected to be manageable given the relative strength of the labor market, and rising interest rates could pose risks to some banks. Strong oversight will be required, including of SMSBs which are less diversified and more vulnerable to a slowdown in activity and shifts in sentiment. On the upside, higher-than-expected growth in the United States, a quicker normalization of supply chains, and faster moderation in inflation would permit a less restrictive monetary stance and boost output relative to baseline.

Macroeconomic and financial policies

The Bank of Canada’s recent rate hike, following its “conditional pause,” was appropriate and reinforces the Bank’s commitment to bring inflation down to target. While the economy is responding to policy tightening, the stickiness of core inflation and continued strength in some labor and housing market indicators have been notable. It will be important for the BoC to maintain a data-dependent posture. This is especially true given uncertainties about monetary policy transmission lags since the pandemic—while excess savings might have made consumption less interest-sensitive, the increases in household debt and variable-rate mortgages cut in the opposite direction—as well as uncertainties about the impact of increased immigration on supply and demand. Should the incoming data warrant it, the BoC should be ready to hike again or keep the policy rate high for even longer than currently envisaged.

The complicated interplay between competing objectives underscores the importance of effective monetary policy communication. The BoC is already very strong in this area, and it continues to make advances, such as starting to publish summaries of Governing Council deliberations and to present alternative scenarios in the quarterly Monetary Policy Report (MPR), as recommended in the IMF’s Central Bank Transparency Review last year. Further improvements to the MPR could include providing quarterly, and not just annual, paths for key variables, and conducting ex post evaluations of inflation-forecast errors—one of which took place last year—on a regular basis. Finally, the BoC could contemplate additional steps to help the market and broader public better understand its reaction function—one possibility in this regard would be for the BoC to consider, at some appropriate time, whether to publish a policy rate path consistent with its economic projections and to revise it on a regular basis in response to incoming data.

Fiscal policy should be kept tight, including to support disinflation goals. The 2023 federal budget introduced a range of important new spending, about two-thirds of which was accommodated by slowing the pace of fiscal consolidation—the cyclically-adjusted general-government deficit is now expected to narrow only slightly this year. Moreover, the federal debt ratio is now projected to rise briefly before resuming its downward path, and it ends the horizon slightly higher than previously projected. While Canada’s public debt is relatively low in international comparison, it remains substantially above pre-pandemic levels. As such, rebuilding fiscal buffers is a priority to face future shocks.

Canada is a strong fiscal performer and could consider adopting a quantitative fiscal framework. Canada has a strong track record of fiscal discipline since the 1990s, and it has unwound almost all of the fiscal support provided during the pandemic. The government’s commitment to medium-term debt reduction provides general guidance but leaves flexibility in the pace of consolidation. Canada could consider a quantitative framework—designed in a way to allow flexibility to deal with exceptional circumstances—in order to guide market expectations, enhance credibility and accountability, and allow an assessment of the various tradeoffs. Such a framework could include a debt anchor, supported by escape clauses that could be triggered in the case of large shocks as well as an operational rule to determine how to return to the anchor following shocks. While it would impose tighter constraints on fiscal choices, it could provide policymakers with latitude to make choices within those constraints. Staff analysis suggests that such a framework could also reduce the output costs of consolidation. Many of Canada’s peers with similarly strong fiscal records have benefited from well-designed fiscal rules appropriate to their own specific conditions.

Meanwhile, financial regulation and supervision could be further strengthened in a few areas:

• Regarding banks, while deposit insurance appears adequate, withmore than 90 percent of depositors covered, there may be scope to further protect depositors at small banks. Separately, the authorities rely on Pillar 2 of the Basel Framework along with other ad hoc stress testing tools to examine capital and liquidity requirements appropriate for each individual SMSB’s idiosyncratic and systemic risks, but there may be an argument, at this unsettled time in the global banking sector, to extend the Domestic Stability Buffer, which was recently increased for larger banks, to SMSBs as well.

• In the case of nonbank financial institutions (NBFIs), more routine and compulsory top-down stress tests performed by federal and provincial regulators would complement exercises currently performed by the institutions themselves. Supervisors may also need additional powers to compel provision of information from pension funds and asset managers, as the current voluntary approach to assessing market liquidity risks from these institutions may have limits.

• Coordination between federal and provincial supervisors could be further strengthened, and efforts are necessary to address data privacy legal provisions that sometimes constrain the sharing of supervisory information.

Progress in strengthening AML/CFT frameworks should continue. Special attention should be given to addressing cross-border money laundering risks, particularly in the banking and real estate sectors. Separately, while ongoing legal reforms to establish the federal beneficial ownership registry are welcome, further engagement with provinces is necessary to ensure pan-Canadian coverage and harmonized approaches to beneficial ownership data collection and publication. Following the establishment of a real property beneficial ownership registry in British Columbia, similar registries are needed in other real estate markets vulnerable to the laundering of illicit proceeds.

Given downside risks, agile policymaking remains of essence. Fiscal automatic stabilizers should be allowed to operate. Monetary policy could be adjusted in either direction, depending on the stickiness of inflation and the strength of external demand. In case of financial stress, existing macroprudential and liquidity-provision tools should be deployed, butif the stress were severe—in which case credit growth and inflation would both likely be dampened—there might also be a need for the BoC to rein in its rate hikes. Financial stress might also justify activation of the temporary authorities currently being discussed to allow the Minister of Finance to increase deposit insurance coverage in a crisis.

Climate and housing policies

Canada deserves substantial credit for its multipronged climate mitigation strategy centered around carbon pricing. As the world’s eighth-largest emitter of greenhouse gases, Canada has recognized that it must be an important part of the global solution. Given the scope of the problem, climate leaders like Canada that have managed to forge domestic consensus in favor of substantial mitigation policies must do everything in their power to maintain that consensus and ensure climate policy certainty, which will help promote the needed investments.

Canada’s announced policies should go a long way toward achieving its nationally determined contribution (NDC) for 2030. While staff analysis suggests that carbon pricing and other policies could produce a 30 percent reduction in emissions by 2030 relative to 2005, the expeditious implementation of all elements of Canada’s Emissions Reduction Plan (including the separate cap on emissions in the oil and gas industry, along with clean electricity regulations) could deliver the 40-45 percent commitment in the NDC. These steps, along with future technological advances, should also help Canada on its road to net zero by 2050. Importantly, negative competitiveness spillovers from carbon taxation across countries can be mitigated through the effective recycling of associated revenues and exchange rate flexibility. More generally, consideration should be given to a differentiated international carbon price floor, an effort that Canada could help lead.

The government’s green subsidies are welcome, although their design could be strengthened. Investment tax credits to clean electricity and green energy and technology featured in the 2023 federal budget, plus complementary measures in 2022, as well as the additional production subsidies recently granted to one automaker and now under consideration for another, can all support Canada’s transition to a greener economy by helping to incentivize investment in key sectors. That said, greater international coordination would be desirable, to mitigate the risks of a “race to the bottom” in which investment-location decisions may be distorted toward jurisdictions able to offer subsidies. Moreover, the current strong focus on electric vehicles—and their batteries in particular—as key to Canada’s green industrial development will require a cautious approach given rapid technological change. International experience also suggests that evenhandedness and transparency can best be served by offering a standard, time-bound incentive regime rather than negotiating company-specific packages. And ensuring that subsidies are designed in a WTO-consistent manner is critical to counter geoeconomic fragmentation.

Finally, actions are needed to promote housing supply and address affordability concerns. In the context of rising mortgage rates and the sharp increase in immigration, additional policy steps are needed to boost housing supply and promote housing affordability. While the Housing Accelerator Fund, introduced in the 2022 budget to provide incentives for municipalities to expand housing supply, is a step in the right direction, more needs to be done to expedite permitting and promote densification. Consideration could also be given to creating a permanent discussion forum for relevant stakeholders, including federal, provincial, and municipal officials responsible for both housing and immigration, as well as representatives of the construction industry and advocacy groups.