Canada: Fiscal policy has the most scope to provide stimulus during the recovery – CIBC

Royce Mendes, Senior Economist at CIBC Capital Markets, points out that Bank of Canada’s QE won’t work by lowering long-term yields or weakening the loonie, it will help by keeping under control borrowing cost for the government. 

Key Quotes: 

“It’s true that small-open economies have the potential to receive a greater economic boost from a weaker exchange rate because they’re more reliant on trade. But with so many central banks globally now implementing some form of asset purchase program, the effects on the loonie from Canadian monetary stimulus are likely to be largely offset by monetary stimulus in other jurisdictions.”

“Even with the Bank of Canada already having cut its policy rate by 150bps and assuming that much of the social distancing measures and required shutdowns are no longer in place by the fourth quarter, we expect that the Canadian economy will still be operating more than 4% below its capacity at the end of the year.”

“Even after the most severe elements of the current shutdowns are lifted, the Canadian economy will likely be operating far enough below its capacity that a large fiscal stimulus package won’t push the Bank of Canada to tighten monetary policy. Indeed, monetary policymakers will likely still be using large-scale asset purchases to keep the government’s borrowing costs in check. The federal government has already committed hundreds of billions of dollars to bridge the gap, but remember that money is just replacing lost income in the private sector from shutdowns. There will still be an important role for fiscal policy when the economy begins to recover to support the healing process. One of the central lessons from the financial crisis was that those governments which chose to provide adequate stimulus for their economies healed much faster than those that didn’t.”

“The bottom line is that Canadian QE likely won’t work in the typical fashion by substantially lowering longer-term yields and depressing the exchange rate. What it will likely be best suited for is keeping a lid on the government’s borrowing costs at a time when fiscal policy has the most scope to provide stimulus during the recovery.”