Mission Concluding Statement 

Canada Staff Concluding Statement of the 2024 Article IV Mission

June 11, 2024

Washington, DC:

Inflation is declining steadily in the context of soft economic activity and a resilient financial sector. Against that background, the Bank of Canada has appropriately begun cutting policy rates. Canada’s public debt and deficits remain low in international comparison, and the recent introduction of quantitative fiscal objectives is welcome. That said, fiscal policy should be tightened, both to support the Bank of Canada’s efforts to bring inflation back to target and to rebuild buffers appropriately used during the pandemic. Measures to address growing housing affordability challenges move in the right direction, but they will take time to bear fruit and will likely need to be supplemented by additional efforts. Further advancing other structural policies, including on childcare, productivity, and climate mitigation, is also of critical importance.

Recent developments

The Canadian economy appears to have achieved a soft landing, staying out of recession even as inflation has fallen substantially. Headline inflation has returned to the Bank of Canada’s (BoC’s) target range—albeit still above the 2-percent midpoint—and has been declining steadily in recent months, with core inflation already below 2 percent on a 3-month annualized basis. At the same time, while GDP growth has slowed considerably—and per capita income has declined for six of the past seven quarters, in part reflecting the mechanical effect of the post-pandemic surge in immigration—a recession has been avoided.

Housing affordability has reached its worst levels in a generation, with mortgage interest rates, rents, and prices all elevated. Housing demand remains strong—reflecting the expectation of rate cuts and the growing population—and although housing starts have risen, builders continue to face a scarcity of skilled tradespeople, high financing costs, and regulatory challenges. Affordability is particularly challenging in rental markets, where vacancy rates have fallen from their historical average of 3 percent to around 1 percent, while rents have surged.

The financial sector remains resilient, with banks well capitalized and liquid. Delinquency rates have risen—as expected given the state of the economic cycle—but remain below pre-pandemic levels for mortgage loans (over half of all lending to the private non-financial sector), although they have reached or surpassed those levels for auto and installment loans. Meanwhile, the commercial real estate asset class in Canada appears less problematic than in other countries, and exposures are also less concentrated than elsewhere. Nonbank financial institutions appear to be sound, although persistent data gaps prevent a comprehensive evaluation.

Outlook and risks

Real GDP growth is set to recover gradually this year—to 1.3 percent, from 1.2 percent in 2023—supported by the expected gradual normalization of monetary policy, some easing of fiscal policy, continued (even if slowing) immigration, and the expansion of the Trans Mountain pipeline. Consumption is set to recover, and while mortgage resets in the coming years will exert a headwind, this should be limited by households’ relatively healthy balance sheets, increased home equity, and a benign unemployment forecast. Inflation is set to gradually decline, reaching the 2-percent target by early 2025.

Risks around the baseline forecast are broadly balanced. An abrupt global slowdown could dampen Canadian growth and inflation alike, while tighter financial conditions, occasioned by stickier-than-expected inflation (reflecting rising shelter costs, continued high wage growth, or a further strengthening of the USD against the CAD), could negatively affect the outlook. On the other hand, labor market resilience and stronger-than-anticipated US growth, as seen during 2023, could lead to a stronger growth outlook.

Macroeconomic and financial policies

With inflation continuing to decline and economic activity soft, the BoC appropriately decided last week to begin lowering its policy rate, making it the first G7 central bank to begin normalizing policy. The monetary stance would nevertheless remain restrictive for a while, and quantitative tightening should still proceed, with securities rolling off the BoC’s balance sheet as they mature. To better guide expectations while containing perceptions of forward guidance, the BoC could also consider further strengthening how it communicates its monetary policy intentions on a regular basis, including by explaining how quickly the policy rate could return to neutral, clarifying how it views market expectations regarding the evolution of the policy rate, or even—as done by several other leading central banks—publishing its forecast-consistent policy rate path (changes to which, from quarter to quarter, could help markets better understand how the BoC reacts to new data). Such possibilities would build on steps already taken to improve transparency, including publishing summaries of Governing Council deliberations and holding press conferences after every scheduled meeting.

Canada’s fiscal track record continues to compare favorably to many other advanced economies—it was quick to consolidate after the pandemic, has maintained relatively low deficits since then, and is targeting further deficit reduction. That said, and against the backdrop of a modest rise of federal and provincial deficits during calendar 2023 and 2024, some additional fiscal consolidation would not only help stabilize inflation but also help to restore fiscal space that was used during the pandemic (when public debt rose sharply). Debt remains low in international comparison, but further consolidation will put Canada in a stronger position to address future downturns as well as structural spending needs related to climate, defense, healthcare, and other critical areas. Thus, while the spending initiatives in the federal budget are appropriate, they should have been offset through greater revenue mobilization. The increase in the capital gains inclusion rate improves the tax system’s neutrality with respect to different forms of capital income and is likely to have no significant impact on investment or productivity growth. Consideration could be given to other changes—such as an increase in the GST rate, while raising the GST credit to shield the poor—so as to deliver a tighter fiscal stance.

The decision to introduce quantitative fiscal objectives in the 2023 Fall Economic Statement and adhere to them in the 2024 budget is welcome. Such objectives usefully complement the government’s commitment to continue reducing the federal debt-to-GDP ratio over the medium term, offering more certainty to the market about the specific path of fiscal policy, helping to crystallize tradeoffs, and strengthening the government’s hand in resisting spending pressures without offsetting measures. Consideration could be given to having a formal public consultation, setting the stage for adopting a formal quantitative fiscal framework. Such a framework could bolster Canada’s already-strong fiscal credibility, which in turn could reduce the possible output costs of consolidation.

While the financial system remains resilient, faster progress in remedying specific data gaps is critical, especially to improve the oversight of nonbank financial institutions, including pension funds. Given these institutions’ importance in financial markets, close monitoring of their liquidity situation is necessary to limit potential market instability. In this regard, consideration should be given to ensuring some form of regular reporting for systemic risk monitoring. Meanwhile, greater priority should be placed on devising mechanisms to ensure rapid and regular information sharing between federal and provincial supervisory entities. Finally, efforts to strengthen Canada’s frameworks against money laundering and terrorism financing should continue.

Structural challenges

Improving housing affordability is a top priority. If it is not addressed, local economies will face difficulties in attracting workers and businesses, and across Canada, homeownership will move further out of reach for younger generations. Metering arrivals of temporary foreign workers and students may offer some breathing space, but the underlying challenge of boosting supply remains. Measures underway to overcome the obstacle of NIMBYism and foster housing construction are expected to produce results over time, but further efforts will likely be needed to achieve the ambitious goal of building 3.87 million new homes by 2031. Specifically:

• Municipalities should continue to reduce red tape, rezone for densification, and utilize public lands. Provincial governments should be bolder in pushing municipalities to act and in using their own policy levers. And the federal government, which has shown leadership in an area not traditionally its own, should continue to use the power of the purse to incentivize municipal governments to facilitate more construction. Finally, all levels of government could do more to promote social housing, which currently accounts for just 4 percent of Canada’s housing stock.
• Measures that inadvertently boost demand should be avoided, and the ban on nonresident housing purchases—a capital flow management measure—would better be replaced by a nondiscriminatory tax on speculation.
• Consideration could be given to the creation of a national forum to address housing issues, with participation of policymakers at all levels of government, as well as home builders, NGOs, and other stakeholders. Such a forum could support coordinated action to address the housing crisis.

Addressing lagging productivity growth is critical to improving Canadians’ living standards. In this regard, more needs to be done to boost corporate investment, which has been weak as a result of dim prospects in the traditional energy sector, a relative lack of large firms, and insufficiently developed venture capital and private equity, among other reasons. In addition, efforts will be required to address interprovincial trade barriers and to better integrate immigrants into the economy.

Despite Canada’s already relatively high female labor force participation—which increased even further last year—more could be done to support participation of women with young children. Staff simulation analysis suggests that the government’s affordable childcare program is likely to deliver an appreciable boost to participation, but only if it is complemented by efforts to train and retain more early childhood educators and to build more centers. This will help ensure that access widens and that fee reductions do not merely serve as a windfall to families currently using regulated and licensed childcare.

Carbon pricing is of essential importance in delivering on Canada’s commitment to reduce 2005 emissions by 40-45 percent by 2030. Calls to replace the retail fuel charge (which is set to rise to C$170/ton) with technology subsidies would imply substantially higher costs of achieving climate goals, as confirmed by staff analysis. While carbon pricing must be complemented by other measures, better coordination of Canada’s many federal and provincial policies promoting carbon abatement could improve the cost-effectiveness of the policy mix and avoid the risk that supplementary measures undercut the price signal from the carbon tax. A holistic review of the system should be considered, along with the creation of a single body to advise the government on climate policy.

In terms of green industrial policy, while Canada is responding to subsidies in the US Inflation Reduction Act (IRA), it should not engage in a “race to the bottom” that could contribute to global fragmentation. The government has laid out various technology-neutral incentives, and it has also made a large strategic call on electric-vehicle battery manufacturing. It should, however, provide a level playing field for all companies and continue to ensure that subsidies are designed in a WTO-consistent manner.

The mission would like to thank the Canadian authorities and all other counterparts for the constructive and candid policy dialogue and productive collaboration.