Thank you, Chair, good afternoon. Good afternoon to committee members. Senior Deputy Governor Wilkins and I are happy to be before you today to discuss the bank's monetary policy report, which we published just last week.
When we were last here in April, we were celebrating the fact that we had upgraded our economic forecast. That was following a long period of disappointment. I'm pleased to tell you that many of the positive trends that we saw then have continued. Sources of economic growth have broadened across sectors and across regions, and the process of adjustment to the oil price shock is essentially complete.
The bank raised its policy interest rate twice since our last visit, in July and September. We did this in the context of very strong economic growth over the first half of the year and solid progress in the labour market.
Over the summer, we saw evidence of firming inflation and an economy that was rapidly closing its output gap. With these two rate increases, we have taken back the cuts we made in 2015, which were crucial in helping the economy adjust to the oil shock.
Growth in the first half of the year averaged just over 4% at an annual rate. This reflected strong consumer spending, backed by rising employment and income, together with increased business investment and a jump in energy exports. We are now starting to see signs of a moderation in the second half, which we forecast in July. Growth in consumption and investment is expected to ease and growth in housing is projected to slow further, in part because of the measures introduced by the Ontario government in April.
All told, we forecast that the economy will expand by 3.1% this year before slowing to 2.1% in 2018. This is still faster than the growth rate of potential. We estimate that the economy is now operating close to its capacity. Inflation should reach our 2% target in the second half of next year. That's a little later than we projected earlier because of the temporary impact of the stronger Canadian dollar this year.
We're at a crucial spot in the economic cycle and significant uncertainties are clouding the way forward. In our MPR, we identified the four most important sources of uncertainty, and I'll just touch on those now.
The first source of uncertainty is inflation itself. There have been several conjectures about the apparent softness of inflation in Canada and in many other advanced economies. Some have argued that globalization is restraining inflation. This could be due to increased imports from lower-cost countries, for example, or the effect of Canadian companies participating in global supply chains. Others point to the impact of digitalization on the economy. They suggest that digital technologies could lower barriers to entry in some sectors and lead to more competition. The rise of e-commerce may be changing price-setting behaviour, and digital technologies could promote innovation and higher productivity, which could create disinflationary pressure.
The second source of uncertainty is the degree of excess capacity in the economy. We note several signs that point to slack remaining in the labour market. For example, the participation rate of young workers is still below trend and average hours worked are less than we would expect. With the economy now operating close to capacity, we expect to see investment by companies, together with job creation by new and existing firms, and rising productivity. This should serve to raise the economy's potential output, increasing the amount of non-inflationary growth that is possible. However, this process is highly uncertain and not at all mechanical, so we have built it into our projection in a conservative way.
The third issue is the continued softness in wage growth. While employment growth has been strong in Canada, wages have not kept pace. The slack in the labour market is certainly responsible, in part, for this effect and there will be a lag between the time the slack is used up and when we see stronger wage growth. However, other factors, including globalization, may also be affecting wage dynamics.
Finally, the fourth issue is the elevated level of household debt and how that might affect the sensitivity of the economy to higher interest rates.
Bank staff have recalibrated our main economic model used for projections to capture key information about housing and debt. This work tells us that the economy is likely to respond to higher interest rates more than it did in the past. However, we will watch incoming economic data closely for evidence to support this idea. We will also look to see how the household sector is responding to the new rules about mortgage underwriting.
We also outline several other risks in our MPR. Taken together, these give us a balanced outlook for inflation. We have not incorporated into our projection the risk of a significant shift toward more protectionist trade policies in the United States, given the range of potential outcomes and the uncertainty about timing. However, we acknowledge that uncertainty about future U.S. trade policy is having some impact on business confidence now and on investment spending as well, and this impact is reflected in our outlook.
In this context, governing council judged that the current stance of monetary policy is appropriate. We agreed that the economy is likely to require less monetary stimulus over time, but we will be cautious in making future adjustments to our policy rate. In particular, the bank will be guided by incoming data to assess the sensitivity of the economy to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation.
As this is a very important message, allow me to repeat it.
In this context, governing council judged that the current stance of monetary policy is appropriate. We agreed that the economy is likely to require less monetary stimulus over time, but we will be cautious in making future adjustments to our policy rate. In particular, the bank will be guided by incoming data to assess the sensitivity of the economy to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation.
With that, Mr. Chairman, Senior Deputy Governor Wilkins and I would be happy to answer questions.
I believe that Statistics Canada tries to have a basket that represents goods and services consumed by Canadians. Statistics Canada tries to weigh those goods and services dynamically, because it changes over time, although not on a daily basis, according to the way in which they investigate how consumption standards change. That is what Statistics Canada does.
Our task is to explain the process of inflation, which could well be influenced by globalization as well as by digital technologies. In fact, many more goods and services are sold on the Internet, thanks to e-commerce. A number of goods are imported from countries that have a different productivity rate than ours, which could influence the dynamics of inflation.
In our monetary policy report, we try to study it in more depth. At the moment, we see little evidence indicating that the dynamics of inflation have changed a lot in Canada. We can certainly explain that with our standard tools, but we are keeping an open mind, because, with more data and with more experience, we may well find more factors.
Certainly, the risk you're discussing is one that's foremost in our minds and has been for quite some time. The elevated household debt not only poses this challenge about how interest rate adjustments occur, but of course actually represents an ongoing vulnerability of the economy to other shocks, such as a new global recession out in the world. What happens is that high levels of debt act as an amplifier. They make the shock have a larger effect on the economy than it otherwise would.
For example, let's say there was a recession in the United States. The sequence would be that unemployment in Canada would rise, folks would have difficulty keeping up with their mortgage payments, and that would cause bigger cutbacks in spending than we otherwise would have.
We have always known that this would be, if you like, a second-order consequence of the primary objective, which is to get the economy back on track, get the economy back to our 2% inflation target, which means full employment. That is the best contribution that monetary policy can make to ensuring that in the long term, these debts are sustainable and serviceable. The fact is that given the shocks we've been through since 2007....
I remember that in 2008 every country in the G20 cut interest rates very low and had a large fiscal expansion in order to offset the consequences of the global recession. I think, too, this was an unqualified success. It certainly averted what I think we all would be calling by now “the second great depression”. All the ingredients were present.
By 2010, it looked as though we had most of the bad news behind us, so fiscal consolidation began to emerge as a priority in lots of countries, but as it turned out, the world delivered a bit of a slowdown, which progressed, and interest rates needed to stay low longer, so we have these consequences of higher debt.
I just want to assure you that we take this fully into account and will be monitoring how households are reacting to those debt levels and interest rates. It's not a simple arithmetic calculation about what they can absorb. The economy will moderate, compared to the levels we have seen, as this process unfolds.
It's exactly one of the scenarios that we considered carefully and have analyzed in some depth.
In our FSR, the financial system review, where most of this risk assessment takes place, we consider risks that have large drops in housing prices, much larger than one could anticipate along with a recession. In other words, the recession causes the housing prices to fall, so the economy has a double layer of shocks on it. In scenarios even as grave as this, the financial system remains highly robust.
It's true that collateral against which people have borrowed is reduced in value, but the financial system itself is very well provisioned against shocks of this sort. Of course, the new Basel accord brings us into that zone. Canada has not had to adjust much to those new accords because we've always had a more robust provisioning system than in many other countries. As a result, we're confident that the financial system itself is not a source of risk, but we consider these to be vulnerabilities, which are more likely, as I was describing a moment ago, to magnify the impact of shocks on the economy.
Carolyn, did you want to add anything to this?
I would just add, aside from the fact that our banks are highly liquid, capitalized, and diversified, there have been other measures aside from interest rates. We've talked a lot about the role of interest rates, but there's a role for macroprudential policies as well.
OSFI, last fall, and then most recently this fall, has taken moves to improve the quality of debt that's out there by providing clarified guidelines to financial institutions that are lending to households about what kinds of criteria they should put in place to make sure the household can withstand increases in interest rates. Here I'm talking about the new stress tests that they put in.
What they did last fall was aimed at the insured space. In the data, you can now see that the share of households that are very highly indebted—those are households that have a loan-to-income ratio of over 450%—has fallen from about 18%, to a little less than half of that now. What they did this fall, most recently, was to look at the insured space—that's quite a growing area—and applied very similar kinds of tests there. It's too early to say what the effect is going to be on that, but over time it will improve the quality of debt so that it will be more resilient to the shocks that the governor was talking about.
That's greatly appreciated, Mr. Chair.
Madam Vice-Governor, you mentioned the macroprudential measures that OSFI has instituted for mortgages that are low loan-to-value; that is, where down payments of greater than 20% are made.
I met today with mortgage brokers who made the point—a point that was also made in the Globe business report earlier this week—that these measures, combined with the uninsured nature of higher down payment mortgages, in many cases lead to higher interest rates for those with bigger down payments than they would pay if they made smaller down payments. That creates a strange perverse incentive to put fewer dollars down on one's house.
I think all of us would agree that we should be promoting bigger down payments because they're less risky to the system and to the borrower.
Do you worry at all about some perverse incentives that may result from OSFI's recent regulations?
What in fact is happening there is that if your down payment is less than 20%, the rules dictate that it must be insured. A mortgage loan which is insured is, of course, a lower risk to the financial institution, so generally it's possible—it's not necessarily the case—that you'd have a lower rate of interest on that.
However, the borrower must pay for the insurance—it's not zero cost, it's actually quite a significant cost—which is rolled into the upfront value of their mortgage, so they are paying for it in a different way. Those folks who have more than a 20% down payment then go to an uninsured mortgage. It's possible that their interest rate will be a few tenths higher, but they're not paying for the insurance, which is a pretty big upfront cost.
I think, in that sense, there's no perverse thing in the space around the decision, and it's a stretch to create a case where you're actually better off in the first case.
My thanks to the governor and the senior deputy governor for being here.
I was also thinking of spending time on the matter of household debt, but I feel that it has been well covered.
So I would like to go back to the relationship between two curves that, in my opinion, can be linked. They are the salary increases in Canada, or rather, as you said, the salaries that are basically stagnant, and inflation. Those two items can be linked because Canadians see increases in the inflation rate, and for basic products, but they also see that salaries are not increasing at the same rate.
Do you see that as a long-term problem for the Canadian economy? Do you have any data on those two issues and the relationship between them?
That is a very interesting question because we are focusing a lot on salaries. It is one of the indices that we are examining to determine whether the pressures on inflation are upwards or downwards.
For salaries, using a number of sources, we can see that the increases are quite small, as you said. In addition, as you can see in figure 2 in the monetary policy report, we have tried to go into the issue a little more deeply. We have seen that we can explain a part of the weakness in salaries by the shock caused by the drop in petroleum prices that we have experienced. That brought about a change in a sector where the jobs came with salaries that were high when compared to other sectors, such as services, where salaries are lower.
In addition, the adjustments in the energy sector itself required small salary increases, and that continues. If you combine that with the labour market indicators, where supply exceeds demand, you can see that salaries are lower at the moment. However, we expect that, as the economy continues to grow, salaries will continue to rise. So there should then be an increase in those rates over time. However, the pressures on inflation coming from the labour market mean that the price of goods and services is lower than it would otherwise be.
The data I have in my head are more about the regional distribution of debt. In total, we know that about 80% of Canadian household debt goes to mortgages and home equity lines of credit.
So it is very significant. Across the country, we see that the most indebted households, those whose debt is more than 450% of income, which is very high, are concentrated in regions where house prices are still very high, like Toronto, Vancouver and the surrounding areas. That is not surprising. It is also the case in Alberta because, beforehand, house prices were high there too. It is the case in a number of regions of the country where house prices are very high, and it comes as no surprise.
Certainly, in those regions, income could be higher too, because it corresponds to the cost of living. But when you look at the debt compared to income, it really is concentrated in those regions.
Thank you, both, for being here again.
Several of my questions are from the fall economic statement, which I know is not your report, but the Bank of Canada is quoted in it in terms of the Bank of Canada's business outlook survey. That's where some of my questions are coming from.
I want to talk specifically here with regard to investments. The fall economic statement talks about the Bank of Canada's business outlook survey showing there's a strong improvement in business investments in terms of intentions over the last year, and that the intentions remain in a solid, positive territory with capacity utilization rates of several industries currently close to their pre-recession peak.
I'm not saying that's what the bank said, but I'm assuming it's based on.... Well, they're saying it's based on your survey. Can you speak to that as well as the fact.... The statement in here is that business investment improvement may prove to be more long term and enduring in terms of continuation.
Yes, the situation as I described earlier is one where we have the economy now, for the first time in many years, operating close to its potential. What one expects to see at this stage of the cycle, then, is firms that find themselves right at their full potential. In some cases, in fact, some 75% of those surveyed in the manufacturing sector say they're operating above their normal capacity level. That would be overtime, and that sort of thing.
When we get to that stage, companies generally begin to invest more, not just to replace equipment but to actually expand their capacity. It could be an upgrade in technology, in which case they might be able to expand their capacity without adding more workers, but very often it's not the case. What happens is that they actually add more workers too.
It is a really important stage of the business cycle for us. We haven't been here for some time. In most business cycles, when you have that upturn, you reach that capacity stage and the forecasters, ourselves included, have a trend line that's the economy's potential. We're saying that we're about at that trend line now.
However, what happens at this late stage is that companies add more capacity and the trend line tilts up for a while and gives us more capacity. When we say there's excess capacity in the labour market, that's where the economy has more room to grow. It means that those people, the discouraged workers, such as those who are working part time, can get a full-time job and those kinds of things. That adds to the economy's capacity.
By our surveys, the economy is primed and ready for this phase. We thought we saw the early signs of it in the first half of this year, and it's very reassuring to see. Despite the concern expressed almost universally about the uncertainty, going forward, about trade arrangements, despite that layer of uncertainty, companies nevertheless are prepared to invest. We take from this that their intentions would be even higher were it not for that uncertainty.
Thank you. Actually, trade is exactly my next question, so that works out well.
Obviously, there is trade uncertainty and protectionist kinds of attitudes, certainly in the U.S. It's not only in the U.S., but in the U.S. it certainly impacts Canada.
This isn't your graph. It was provided by the OECD. It talks about labour productivity growth. Certainly in terms of aging population and demographics, Canada has concerns and we've talked about that here, but then I look at the United Kingdom and it's below 0.5%. It's probably 0.3%, but I don't know because it doesn't show all the numbers. Isn't there a huge opportunity through CETA, and I get it with Brexit with the U.K. specifically, but if there is a specific trade deal between Canada and the U.K.?
I see their labour productivity growth being extreme. If I were in the U.K., I'd be very concerned. Although there's uncertainty, is there not a huge level of opportunity and optimism, given the fact that Canada has changed between 2000 and 2007, and now it's not as significant when you look at the U.K. as one example?
Right. It's a more complex question than it sounds, because productivity as measured there captures a lot of things in the economy. You could imagine if the U.K. was creating a lot of new jobs, but let's say the average job being created was in the service sector at a lower productivity level than in the financial sector, which is a high-productivity sector, or in manufacturing, which is high productivity. The mix of jobs can affect those numbers quite significantly.
I'm happy to say that Canada's labour productivity has picked up very strongly over the past year and a half to two years. Part of this is, no doubt, cyclical because it is the economy shaking off the collapse in oil prices and moving on to growth in other sectors, but it's also probably related to the thing I was mentioning a moment ago to your earlier question, which is that investment is picking up. If a company hasn't been investing, say, for five, six, or seven years, making their capital last, now every dollar they spend can have a big impact, because it's new technology or just upgrading things.
In addition, we now know that some companies can invest without there really appearing to be any investment. They do something in the cloud. They buy a service in the cloud instead of investing in the equipment themselves, and it looks as though the investment hasn't gone up, but we get the impact as if they had invested. The data are going to be increasingly difficult to interpret. StatsCan is all over this to help us understand it, but all that to say, we are at an encouraging stage here in Canada.
Central banks never comment on one another's policies. It's just not done.
But the Federal Reserve has telegraphed its intention over time to move interest rates higher, and it has these dots, which are essentially the forecasts of the members of the committee, which suggest that interest rates would rise over time but at an undetermined pace.
We have discussed divergence in the past precisely because conditions changed so much in Canada relative to in the United States. In particular, when oil prices fell, that was of course a negative for Canada but it was actually a positive for the United States, because even though they have an oil sector, they're a net oil importer, whereas we're an exporter. In those conditions, in 2015 the Bank of Canada cut rates twice while the Federal Reserve actually raised rates that year.
That's about as sharp a point of divergence as one can imagine, and that's why we have flexible exchange rates to deal with those kinds of shocks.
Moving forward, I would say, roughly speaking, that Canada has just now gotten to the stage it was at before the oil price collapse, almost three years ago now. The end of 2014 was when oil prices really started to crumble.
I think that over that two and a half years or so, the U.S. economy has gotten out in front of us, whereas we were roughly in the same place when the oil price did go down. Now we're that couple of years behind in the cycle, if you like, compared to where they are. That's why I was expressing the hope before that we will do something similar to what's happened in the U.S. They were able to grow beyond what most people thought was their capacity limit by pulling people back into the workforce, and that's exactly what we think will happen here. It's very hard to quantify. We just have to continue to watch it happen in real time.
This was a risk that we highlighted in our January monetary policy report, very soon after the U.S. election. At that time, the talk was about very significant changes in U.S. tax policies, and the market had absorbed that more or less as fact. What happened over the course of the next six or eight months was that the market reaction was gradually peeled back as the realities of the political process unfolded.
We, of course, acknowledge that there is potentially a risk that there will be a tax change that somehow makes it, on the margin, more attractive for a company to expand its operations or create a new operation in the United States. This is exactly the same strategy that companies are mentioning to us today in response to the risk around NAFTA—that if NAFTA were to cease to exist or be dramatically changed, one way for them to hedge against that risk, since it may take quite a long time for it to become clear, is for them to expand their operation in the United States instead of expanding in Canada.
This is a risk that we face today. In our forecast, we have lower investment spending expected for this reason, this uncertainty, yet as I said before, on top of that there still seems to be a strong willingness to invest, and the actual numbers are showing it.
It's a mixed kind of picture. That's all I have for you.
Thank you, Mr. Chair. I'll try to return some civility to the meeting.
I have a couple of questions. First of all, the October monetary policy report, on page 11, talks about consumption growth and what the Canada child benefit has meant for Canadian families since the report was released, or near the same term. In the fall economic update, we introduced the indexation of the CCB, which will give Canadian families $5.6 billion of extra spending out to 2022-23, and about half a billion dollars a year invested in the working income tax benefit. I think this is wonderful, because it will hopefully draw in people who are not in the labour force to come into the labour force, and provide a cushion to folks whose marginal propensity to consumer-invest is actually pretty high.
I was wondering if you could comment on what it could do to the Canadian economy in terms of firming up consumption going forward.
Governor, we all know how hard it is to time fiscal policy or monetary policy, and monetary policy tends to operate on more of a lag, but fiscal policy, done right, is right. I think the CCB, from my view, was a timely measure introduced by our government.
I'm going to ask two questions together just so I can have the answers and not run out of time. First off, they say the Lord giveth and the Lord taketh away. There was some monetary policy that was removed through your actions. I'm just curious about the monetary transmission mechanism in terms of the time frame that we're looking at to see how the rate increases are impacting or working on the economy. With that, in your introductory comments, you talked about elasticity. We understand elasticity to a price change in terms of where household debt levels are and how there may have been a structural adjustment in terms of how households respond to changing rates.
I was wondering if you can comment, more on the latter than the former, because that is important. A small change in rates may have a larger impact than in prior years.
As for my second question, you commented about the economy operating at close to capacity, but your preferred measure for the labour market indicator demonstrates some slack. If you can square the “close to capacity”, because I think the Canadian economy has grown in capacity or output potential, and you can comment on that as well.
Okay, I'll take the second question, and then I'll turn it over to Ms. Wilkins.
When we talk about the output gap or the economy's capacity, one is a broader concept than the other. The output gap refers to output, production, and we believe we are operating more or less at that level at this stage. Economic potential is a broader concept that includes using all of your existing labour supply.
What we see—and our labour market indicator in particular shows—is that it is still a percentage point higher than it was in 2007, whereas the unemployment rate is where it was in 2007. That shows that those secondary measures of capacity and labour market still have slack, and we won't be fully at our capacity until we've re-employed those resources through stronger investment. That's the process I was talking about before.
For a while we'll have a gap between those two measures. It's as simple as that.
On to the interest rate elasticity, I'll ask Madam Wilkins to comment.
We made quite a bit of modelling changes to make sure we could capture the main channels. The intuition behind why interest rates have a stronger impact when we're highly debted is pretty clear. If you have a $500,000 mortgage, 25 basis points is about $60 a month, and that's going to be taken out of the money that you have to spend on other things. All else being equal, consumption is going to go down a bit, or be less strong than it was. If you had $100,000 mortgage, that would be $12. It makes a really big difference.
It may be that it affects people differently over time, depending on whether they have a variable rate mortgage or a fixed rate mortgage, but eventually that transmission gets through the system. In general, it's six to 18 months, a 24-month process, and it flows, not only through consumption but also through the price of houses, because again, if you're spending more of your income on something else, like interest rate payments, maybe you're not as inclined to buy a bigger house than you were. Maybe other people need to wait longer to buy a house, so all these channels come together to mean that, when people are more highly indebted, it's going to have a larger impact.
With our new model, we are more confident than we were in the past that we've been able to capture those effects.
I'm going to continue discussing some of the mortgage related parts we've already begun today. When it comes to housing, Canadians don't choose to be heavily in debt from mortgages. They participate in the market they live in, and the price is the price. We know that in many centres the prices are very high, and if a person is going to own their own home they must take on these large debts.
I want to make a comment about a point, Governor, that you spoke about, the trade-off between a consumer choosing to pay the insurance fee for a high-ratio mortgage as opposed to putting the additional money down. I've been a mortgage broker for over 20 years. When a borrower is confronted with the choice between a lower interest rate, paying an insurance fee that's amortized over the life of the mortgage, and the option, then, to put less money down, almost every borrower chooses the lower down payment. That's just a human nature type of decision that most people will make. This business about perverse incentives, I think, maybe ought to be a concern over what behaviours are being encouraged.
The changes to OSFI's rules and other changes are not the normal things that are in macroeconomic models, whereas interest rates are obviously in our models. It requires a little extra and more innovative analysis. We have microdata, which was alluded to earlier.
We know, for example, how many people who qualified for mortgages in 2016 will not qualify for them under the new rules and how much less they can borrow. We were able to do almost a simulation, as if we had put the rules in place earlier. We can do that and we can then translate it into an approximate effect on the economy, on the order of 0.2 or 0.3 percentage points in the subsequent year or two of GDP. If it's growth, then it might be half that over two years, or if it's faster it will be all in one year.
Importantly, the way one reacts is an individual decision. Here are the new rules; what do you do? This is the house you wanted to buy, and now you don't qualify. Is your reaction to postpone for a year? Possibly. Is your reaction instead to say, “I think the house next door, which is a little smaller, suits my needs as well, so I'll buy that one instead”, in which case you still go ahead with the transaction.
It's very hard to know how it actually translates into GDP impacts. This is exactly why we say, with the new level of interest rates today compared with those of six months ago, that we need to monitor very carefully how people are actually behaving in real time. We can't just rely exclusively on our models to do that.
We have three minutes, time for about three more questions.
Before we move on—and you partly answered this question earlier to Ms. O'Connell—you said in your remarks, “The second source of uncertainty is the degree of excess capacity in the economy” and “slack remaining in the labour market”, and you used the example that “the participation rate of young workers is still below trend and average hours worked are less than we would expect.”
When we were on the road, as we have been for two or three weeks with the pre-budget consultations, we heard everywhere about the need for greater education, more skills training, matching skills to meet jobs, etc. I'm not asking you to suggest policy, but I'm asking you for your analysis. Is there a problem with skills in the labour market that you're seeing in your analysis? Is there more part-time work than there is full-time work? What analysis does the Bank of Canada have there?
All of these things may be true, Mr. Chairman. We know there are structural changes in the economy and that there's extra growth in part-time working arrangements as opposed to full-time arrangements. Taking account of those things, it still appears to us there is excess capacity in the labour market. It is primarily a youth thing, but not entirely. We have five percentage points lower participation in the workforce by youths aged 15 to 25 than we had prior to the great financial crisis. Now I realize we're talking about different people now, because 10 years have gone by and they may be staying in school longer—which is all well and good, and the effect of a recession is often that people spend more time at school—but the fact of the matter is that we believe there's extra capacity there.
We've tried to quantify that in a separate paper, which was published alongside our monetary policy report. In fact, we simulate the effect. If we're able to get an extra one percentage point of extra economic capacity by this reintegration into the workforce—more conversion from part time to full time and reparticipation by those youths—that is a very significant thing for us to achieve, whether it's done by helping through other policies to make it easier, re-skilling them, or by other means.
All those things can help us, but it also means, to the extent that it occurs, that we will undershoot our inflation target one and a half to two years from now. Therefore, we have to watch for it happening, and hope that it will happen to a certain extent and that we can allow it to occur by watching it unfold and not nipping it in the bud.
Earlier, I think you alluded to e-commerce and to the share of the economy it is taking. In the digital era, that goes without saying. E-commerce is profitable for Canadian companies, but it is also profitable for foreign companies that are flooding the market with poor-quality, low-cost products.
Do you have any data on e-commerce, specifically in retail but also in the cultural area, and on the extent it occupies in our economy today?
Are there any forecasts or concerns that you would like to share with us about the scale of it and the fact that our Canadian companies must compete with those companies?
China comes to mind, which sends cheap products to Canada at very little shipping cost.
Are you going to be watching these situations on your radar screen?
We are certainly monitoring that type of situation closely.
Given our mandate, it will come as no surprise that we are more concerned with the effects and the process of inflation. But we are also looking at the possibility of transition costs in a labour market where the nature of employment changes with use, or even with the effects on people's income.
As for inflation, we conducted several studies that have been published for a week. They are interesting because they show that the effect of e-commerce on inflation in Canada does not seem to be very visible at the moment, even though, anecdotally, we might be led to believe the opposite. The number of Canadians embracing e-commerce is lower than in other countries, such as Sweden or other European countries. However, that could change, and it is true that it represents another kind of competition for Canadian companies.
As for employment, we are not currently seeing the effects of the digital revolution on productivity. It is yet to come, but we can well imagine that the nature of employment will change greatly and we have to be ready for it, both for people coming into the workforce and for those who are already in it. Training and education are very important factors. However, that is not part of the Bank of Canada's mandate. We just do studies in an attempt to better understand it all.
Those, of course, are exactly the questions that keep central bankers awake at night, so I won't deny this. Most of the history of technological improvements—or, if you like, the effects of globalization or supply-chaining—on the inflation process has been to reduce inflation below what its trend line had been. This is what we call positive disinflation. It means that people are getting things for less money.
It would be odd for a central bank to try to boost inflation in other parts of the economy to try to average it out to be exactly 2%. It's the kind of thing we would normally see through precisely for that reason, and because it's unforeseeable, as you say. It's quite similar to an exchange rate effect on inflation, which is transitory one way or the other. We would see through it.
Our greater concern—and this is how the risks become balanced—is that we are now in a place where we're operating more or less at capacity. We believe there's extra capacity, but it has to occur for it to be relevant. If there isn't, it means that we'll be into the excess demand space, and inflation fundamentally will begin to pick up. We would see that in the labour market first. This is why we watch each of these things as we go along.
We're in that zone where those risks are truly two-sided, up or down on inflation, so of course we worry about both sides, but given our history—where we've been for the last number of years—we're much more preoccupied with the downside risks.
This is a question that depends on the divergence in the inflation paths in the two countries. In the example that I gave there was a swing of some 75 basis points between Canada and the United States during 2015. There have been other episodes similar to that.
The truthful answer is that it only depends. I couldn't speculate on what is the maximum divergence we could sustain, but it would just depend on the underlying shocks.
I remember studying the early 1970s when Canada first went back to a flexible exchange rate. There was a massive divergence between the Canadian and U.S. economies at that time, and the exchange rate, as soon as it was unleashed, rose by some 10¢ in a very short space of time because of that divergence.
Really, I think the most important thing that helps us equate when there is a divergence is the exchange rate. Interest rates are less the engine of correcting that. They're more of a facilitator, if I can put it this way.
We shall reconvene. Before we start with the parliamentary budget officer, we have some committee business to deal with. Members have a report from the subcommittee on committee business going forward. I'll just go through it and then we'll see if there are questions.
Point one we talked about this morning. We had a little difficulty figuring out how to deal with embargoed copies. We agreed that an embargoed copy of a report from the parliamentary budget officer, 24 hours before it is made public, be distributed to members of the committee, and the report remains confidential until it is made public by the PBO.
Point two, the pre-budget consultations are explained in the report. People may not be aware of a couple of things. We agreed that the draft report contains an executive summary describing the main themes of the report, and that the committee include a statement in the report from the trip to Washington, D.C., and New York; that the parties submit their proposed recommendations to the clerk in both official languages, no later than 5:00 on Thursday, November 30; the committee meet on Monday, December 4, and Tuesday, December 5, from 3:30 to 5:00 to consider the draft report; and the committee meet on Wednesday, December 6, from 3:30 to 5:00, if necessary, for further consideration of the report. That is all on the calendar and it's marked in yellow.
Point three, we agreed that the clerk proceed with planning the committee trip to Washington and New York, according to the draft itinerary, as discussed by the subcommittee.
Then point four, turning to Bill , the budget implementation act, I think it would be better to explain this by the calendar rather than going through the recommendations. It's there before you. On November 2, the committee would meet with departmental officials, and that 5:00 p.m. would be the deadline to submit to the clerk the witness lists for Bill .
On Tuesday, November 7, the committee would meet and hear from 12 witnesses or thereabouts. On Wednesday, November 8, and this relates, Pierre, to the motion that you tabled, we would meet with the minister from 3:15 to 4:15 on supplementary estimates; we would have the minister before us from 4:15 to 5:15 on the bill itself, Bill ; and if necessary, from 5:15 to 5:45 we would deal with the remaining representatives from the departments.
On Thursday, November 9, we would again hear from witnesses from 3:30 to 6:30, related to Bill . That would be in the range of two panels, six witnesses each. November 16 at 12 p.m. would be the deadline to submit amendments for Bill . Then on Tuesday, November 21, we would go through clause-by-clause consideration of Bill , and be in a position to report it back to the House. That deals with the Budget Implementation Act.
We have to finish by what it says in the motion here, nine o'clock that night. I'll read this into the record so we're clear:
||if the Committee has not completed the clause-by-clause consideration of the Bill by 9:00 p.m. on Tuesday November 21, 2017, all remaining amendments submitted to the Committee shall be deemed moved, the Chair shall put the question, forthwith and successively, without further debate on all remaining clauses and proposed amendments, as well as each and every question necessary to dispose of clause-by-clause consideration of the Bill, as well as all questions necessary to report the Bill to the House and to order the Chair to report the Bill to the House as soon as possible;
That would be the end on the bill.
I mentioned point five. That would be dealing with the supplementary estimates (B). The Minister of Finance, as I mentioned, would be before the committee on supplementary estimates on Wednesday. As well, the Minister of National Revenue and department officials would appear before the committee on Thursday, November 23, on the estimates for that department.
That's the report.
(Motion agreed to)
The Chair: Thank you, PBO officials, for your indulgence while we dealt with that matter.
Pursuant to Standing Order 108(2), we have a study of the economic and fiscal outlook. We have before us, for this panel, the Office of the Parliamentary Budget Officer, Jean-Denis Fréchette, PBO.
I'll let you introduce your people. The floor is yours. I know you have an opening statement. Welcome.
Good afternoon, Mr. Chair, Vice Chairs, and members of the committee.
I am joined by my colleagues Mostafa Askari, Deputy Parliamentary Budget Officer, Chris Matier, Senior Director, Economic and Fiscal Analysis, and Trevor Shaw, Economic Analyst, also with the Economic and Fiscal Analysis team. We are grateful for your invitation to appear to discuss our economic and fiscal outlook for October 2017. As you know, these are part of the PBO's legislated mandate, in order to promote greater budget transparency and accountability.
As members of the committee may know, this report was prepared in response to the motion adopted by this committee on February 4, 2016. However, since then, the PBO legislation under the Parliament of Canada Act was amended. It is therefore in accordance with that legislation that yesterday we provided a copy of the report to the chair and the clerk. We made the report available to the public one business day after, that is, this morning.
Going back to the report, regarding the economic outlook, the Canadian economy advanced at a robust pace in the first half of 2017. However, beginning in the second half, we project that growth and consumer spending will moderate and residential investment will continue to decline as borrowing rates rise and disposable income gains diminish.
We project real GDP growth to slow from 3.1% in 2017 to 1.9% in 2018, and then average 1.7% annually over 2019 to 2022. Nominal GDP, which is the broadest single measure of the tax base, is projected to grow at 4.1% annually, on average, over 2017 to 2022. Compared with our April outlook, the projected level of nominal GDP is broadly unchanged.
We assume that the Bank of Canada will maintain its policy interest rate at 1% until January 2018. As core inflation continues to firm through 2018, we project that the Bank of Canada will gradually increase its policy rate by 25 basis points each quarter until it reaches its neutral level of 3% by the end of 2019.
Our economic outlook reflects the view that possible upside and downside outcomes are, broadly speaking, equally likely. In terms of downside risks, we maintain that the most important risk is weaker business investment. In terms of upside risks, we maintain that the most important risk is stronger household spending.
On the fiscal outlook, the budgetary deficit in 2016-17 was $17.8 billion. This is $2.8 billion lower than we projected in April, reflecting lower than expected direct program expenses, due in part to an estimated $2 billion in unspent infrastructure funding.
For the current fiscal year, 2017-18, we expect that the budgetary balance will show a deficit of $20.2 billion, which is 0.9% of GDP. We project that budgetary deficits will decline gradually, falling to $9.9 billion, which is 0.4% of GDP, in 2022-23. Lower direct program spending accounts for most of the reduction in the deficit over the projection horizon.
Compared with our April outlook, we are projecting budgetary deficits that are $2.2 billion lower, on average, from 2017-18 to 2021-22.
In budget 2016, the government committed to reducing the federal debt-to-GDP ratio to a lower level over a five-year period ending in 2020-21. This translates into a fiscal target of 31% or lower for the federal debt-to-GDP ratio in 2020-21. Under current tax and spending plans, we project that the federal debt-to-GDP ratio will be 29% in 2020-21, which is two percentage points of GDP lower than the government’s target.
Given the possible scenarios surrounding our economic outlook, and on a status quo basis, it is unlikely that the budget will be balanced, or in a surplus position, over the medium term. However, it is likely that the federal debt-to-GDP ratio will fall below its target level of 31% over 2017-18 to 2022-23. We estimate that there is, approximately, a 70% chance that the federal debt-to-GDP ratio will be below its target.
Lastly, in our report published today, we also provided some tables comparing our economic and fiscal projections to the government's projections presented in the fall economic statement. Consistent with the PBO's legislated mandate, we plan to publish an analysis of the fall economic statement in the coming weeks.
Once again, my colleagues and I would be pleased to answer any questions you may have about our economic and fiscal outlook or any other analysis.
Thank you, Mr. Chair.
Thanks for the question.
On business investment, our outlook over the first three years is a bit stronger than the Bank of Canada's. We have a bigger rebound in business investment growth. At the same time, we also have a more, let's say, negative outlook on the residential sector, so we have a bigger decline in residential investment over that period. Part of that, as the governor mentioned—I caught the last couple of comments—is that investment helps to increase the productive capacity of the economy and boost potential growth, so that's being reflected in our outlook.
The risks that we identified are definitely what we see as the most important upside and downside risks. I'm not sure I can give you a top three and bottom three, but the others that are definitely under consideration relate to U.S. trade policies. Again, this is something that several other forecasters have pointed out, based on the uncertainty around NAFTA, of course. Then on the opposite side of that, coming from the U.S., is U.S. fiscal policy and talks about tax reform and tax reduction, so we see that as a possible upside. The way that we treated that in our forecast is that we just assume that they would be offsetting. That's definitely a judgment call and we're open to that.
There are some others, both global and domestic. On the domestic front, we could see a sharper correction in the residential sector than we currently have. We think that it's considerable, but given some of the recent changes on the mortgage underwriting guidelines and maybe a larger impact of the expected increase in interest rates, that could have a more negative impact on the housing side.
Our export outlook is also, I don't want to say, very optimistic, but we do see bigger pickup in terms of growth in export volumes, at least relative to the Bank of Canada's outlook. Maybe on the downside, if we do see another persistence in competitiveness issues for Canadian exporters, we might not see that rebound.
Those are probably the top two and bottom two.
My thanks to all the witnesses for being here.
I saw a picture posted by my friend Jason on Facebook, which put into perspective the difference between a million and a billion. When we talk about billions, as in the case of the public debt charges my colleague was referring to, my friend was comparing one million seconds versus one billion seconds, one million seconds being the equivalent of 11 days, and one billion seconds being 31 years. So this puts into perspective the scale of the numbers we are talking about here and the increase in public debt charges from $24 billion to $38 billion.
My first question is about table 5 on revenues, particularly about the corporate income tax. Did you take into account the recent announcement reducing the tax on small and medium-sized businesses from 10.5% to 9%?
As Chris mentioned earlier, we haven't taken into account explicitly in our projection the issue of trade and uncertainty with NAFTA and the negotiations with the United States, because it's very hard to know exactly what is going to happen and how the negotiations are going to end finally. There is certainly a downside risk, if the negotiations don't go in our favour.
On the other hand, there are other things that we have not taken into account in that regard. The U.S. economy may actually perform much better than we are assuming in our projection, given that they are planning to significantly reduce their taxes and invest in infrastructure. Those things are on the two sides of this, and we haven't taken them into account.
Trade, though, is always an important issue for Canada, given that we are a small, open economy. While that uncertainty is important, we are expecting, as I said, that trade will contribute to growth over the next five years. This expectation is always subject to some risk and uncertainty, naturally.
This is a question I did ask the Governor of the Bank of Canada was. If you see what's happening in the United States, the stock market going up, and you see a lot of investment pouring in, higher bond yields, all those things, how do we look at the investment that the Americans are drawing in vis-à-vis Canada?
Does Canada, in your opinion, still look like a good place to invest? I know we benefit from being a small open economy just north of the Americans, but they're also competitors. Do you have any views?
We do this exercise every year just to show what happens in the long run if the current fiscal structure is maintained over a very long period of time, 75 years. We impose on that the demographic projections that essentially show the aging of population in Canada, both for the country as a whole and also for different provinces. That exercise essentially looks at this fiscal structure and then moves that forward for 75 years and sees what happens to debt, and debt as a share of GDP. That's how we calculate this number of 1.2%.
Over time the current fiscal structure in Canada at the federal level is such that you are going to have this fiscal room of 1.2%, which means that the debt-to-GDP ratio, based on the current projection that we have done over a long period of time, continues to decline. In order to maintain that at the current level, then you can still spend more money, as we mentioned, $24.5 billion, or 1.2% of GDP, or reduce taxes by that amount. What that does is it maintains the current debt-to-GDP ratio at that level for 75 years.
If you don't do that and you leave the current structure unchanged, then the debt-to-GDP ratio will continue to decline. As we show in our report, the debt, eventually, will be eliminated.
This might seem like a somewhat silly question, but I find it interesting that we're looking at our debt-to-GDP ratio. That's the measure we always use. Canada's in a very good position, especially compared with other countries. When you talk to the average Canadian or regular person in terms of that scenario, it's really hard to explain what that means and why Canada is seen as being in a very good position on that measurable.
My somewhat silly question is this. How would you explain, or how do you really talk about the debt-to-GDP ratio and what that means, to the average Canadian, in the sense of how most Canadians look at debt as something you want to pay off? That is your goal, to pay it off. As governments go, that's ultimately the goal as well, except that being in this low debt-to-GDP ratio is really a good scenario.
Is there a simplified way of how we explain this to Canadians in terms of Canada's current position, and why it is seen to be in such a good ratio, and why this ratio is seen as a positive element?
I ask that question. I say it might be silly in the sense that we talk about it very clearly here, but I find that when I go back to the riding and you say that statistic, well, what does that really mean?
I do just also for the record, Mr. Chair, want to comment on what Mr. Grewal had said earlier. In commenting on the debt-to-GDP ratio being projected perhaps to drop to 29% versus 31%, he characterized that as a commitment that they had made. I want to remind the committee that the commitment that was made in the election campaign was not a 31% debt-to-GDP ratio. It was in fact to run a maximum $10-billion deficit with a return to surplus by 2019.
Having said that, I'll go to the questions and pick up perhaps on a theme arising from a response to the very first questions that my colleague, Mr. Sorbara, raised, and this was in regard to the negative impact on the housing market and on Canadian households when interest rates rise as they're expected to do.
We have heard throughout, in this panel and in the earlier one, about just how difficult it is to forecast the future and all of the different factors. We've heard repeatedly that there are an infinite number of variables and so it's very hard to know for certain what is ahead of us.
How much risk is there to projections of a reduced debt-to-GDP ratio and indeed to continue increased deficits that are ultimately, as my colleague, Mr. Poilievre, pointed out, borne by Canadian households through taxes? What are the risks of these projections not being made if, for example, there was even a slightly larger rise in interest rates than what you have already included in your projections?
I'm not going to comment on what the government's fiscal target or policy should be with respect to having a balanced budget or not. That is a political choice.
Economically speaking, there is nothing requiring a government to run a balanced budget year after year or only in certain periods. In our longer-term framework what we've tried to stress is that, at least according to conventional economics, it's the debt-to-GDP ratio. Even with a relatively stable debt-to-GDP ratio, that would imply or be consistent with relatively small budgetary deficits, on balance, over the cycle.
In terms of the shock absorber, to respond to your question about what would happen in the event of a severe downside shock, that's simply the case where the government would have to go and borrow and absorb part of that shock. Again, if it's a very extreme financial market shock where the government couldn't go and issue debt, that's a very extreme scenario. In all other cases of relatively slower growth or weaker oil prices or something, that probably would be absorbed with just issuing more debt and running larger deficits temporarily.
Mr. Fréchette, my thanks to you and your team for your hard work. It is very much appreciated. I enjoyed the work of the Parliamentary Budget Officer before I became a member of Parliament and I appreciate it more as a member of Parliament.
I would like to come back to your report on the economic and fiscal outlook. I am referring to Figure 6. My colleague Mr. Dusseault talked a bit about it and I would like to ask you a few more questions.
With the 70% confidence interval—I know this is the least accurate interval—we can see the possibility of accumulating a deficit of about $30 billion or having a surplus budget just over $10 billion by the end of the 2021-22 fiscal year.
It may seem a bit crass to you, but can you explain how it is that your forecasts present us with both the worst and the most optimistic of situations?
The 3% level that we have assumed in our base case is consistent with the Bank of Canada's estimate of its policy rate when inflation is at its target, when the economy is at its potential capacity, and when there aren't any temporary shocks.
In putting this together, essentially we've looked at the Bank of Canada's monetary policy report and at current levels of interest rates. We know, according to the bank, that inflation will be at its target in, I think, the first half of 2018. The economy will essentially be at its productive capacity or potential output. I don't think the bank has flagged any temporary shocks, so, implicitly underlying the Bank of Canada's forecast, our conclusion is that interest rates are going back up to 3%. They're the ones who set the policy rate, and if their judgment is that 3% is the right number, we're going to take them at their word and that will be in our forecast.
Of course there will be shocks, going ahead. Some of our underlying assumptions won't pan out, and interest rates could be higher or lower than we're projecting on our way to 3%, or its neutral rate. It would obviously be helpful if the Bank of Canada were to publish its policy rate path, going forward, but you can read between the lines. It's clearly indicated in the report that 3% is what they believe is consistent when inflation is at its target and the economy is at its productive capacity or potential output.
I would also like to have those data, which clearly show that government revenues are increasingly coming from individuals rather than corporations.
Let me go back to table 6, which deals with elderly benefits. My question is about what I consider a demographic problem, which we will be facing in the future. According to the table, elderly benefits were $48.2 billion in 2016-17 and will increase to $66.9 billion in 2022-23, which is significant. I, for one, wonder how significant it is if we consider the big picture.
In your opinion, are demographics and the continued increase in elderly benefits problems that will eventually come up in Canada? What percentage of the total government budget do elderly benefits represent? Is there an increase in those benefits compared to the total government budget? If so, is that a problem?