WASHINGTON, USA – The Canadian economy was operating at close to capacity and had strong policy buffers when the COVID-19 pandemic hit. The authorities took strong and well-coordinated policy actions at the onset of the pandemic that provided crucial support to the economy and the functioning of financial markets, and helped protect lives and livelihoods.
The nascent recovery that started when virus-related restrictions began to be eased last Spring has slowed as renewed restrictions were deployed to mitigate a second wave of the virus. Going forward, as the vaccination program proceeds and the economy transitions from crisis mode to recovery, it would be vitally important to contain the spread of COVID-19, and to avoid a premature withdrawal of policy support.
The federal government’s approach to the withdrawal of policy stimulus is a step in the right direction, but clear and credible communication about the path to normalcy will be key. Beyond the pandemic, it remains necessary to continue implementing structural reforms to increase the productive capacity of the economy and promote sustainable and inclusive growth.
Policy Response to COVID-19
The authorities took timely, decisive, and well-coordinated policy actions in response to the pandemic. Canada’s strong history of prudent policymaking afforded it the policy space to respond forcefully to the crisis and avert much steeper declines in economic activity and employment. The size and scope of policy support has been unprecedented. Direct fiscal support provided by the federal government is expected to amount to almost 15 percent of GDP and includes spending on healthcare, and support for households, firms, and vulnerable groups through cash transfers and wage subsidies.
In addition, the federal government provided liquidity support through tax deferrals, credit facilities, and loan guarantees. At the same time, the Bank of Canada responded by cutting its policy interest rate to an historical low and announced a range of programs to support liquidity in the financial system. An array of other financial sector policies was also deployed to support banks, insurers, and pension funds.
From crisis management to supporting the recovery
The path of the recovery is inexorably linked to the evolution of the pandemic. Following an estimated contraction of 5.4 percent in 2020, real GDP is now projected to expand by 4.4 percent in 2021 as the pandemic fades. A more favorable growth projection than outlined in the January WEO update mainly reflects better-than-expected high-frequency indicators. The outlook is, however, subject to both upside and downside risks. On the one hand, the adoption of fiscal stimulus in the United States, the size and timing of which remains uncertain, higher oil prices, and stronger-than-expected pent up domestic demand are important upside risks.
On the other hand, the recovery could be delayed by new waves of the virus. Hence, swift vaccination of the population should remain a key short-term policy priority. However, even as rapid progress is made in vaccinating a large swathe of the population, which could realistically take several months mitigation efforts must continue. These efforts should focus on reducing the risks associated with social contact while minimizing economic disruptions.
The crisis exposed gaps in Canada’s social safety net that should be addressed. The significant job losses at the onset of the crisis put pressure on the employment insurance (EI) system, and many Canadians did not qualify for income support. These factors prompted the rapid rollout of the Canada Emergency Response Benefit (CERB) to help fill the gaps. By the time the CERB expired in September 2020, 8.9 million people (almost a quarter of the population) had applied for the benefit. When the benefit ended, many of the CERB claimants transitioned to a newly revamped EI system, and those still not covered by the revamped system transitioned to temporary recovery benefits. The lessons from the crisis represent an excellent opportunity to review the EI system, including its role as an automatic stabilizer.
The federal government could consider developing a more systematic framework for cyclical stabilization. For instance, linking discretionary fiscal spending to a timely and well-understood macroeconomic variable that reflects the cyclical position of the economy (e.g., the unemployment rate) could provide an automatic trigger for both initiating emergency spending and its withdrawal. These enhanced automatic stabilizers could maximize policy effectiveness over the business cycle and reduce uncertainty related to policy decisions. In the current context, for example, the expiration of some emergency support programs (e.g., recovery benefits and wage subsidies) later this year could complicate decisions of households and firms, add to uncertainty, and potentially increase fiscal costs.
The federal government’s data-driven approach to the withdrawal of policy stimulus (its “fiscal guardrails”) is a welcome step in the right direction, but requires more clarity. The approach represents a strong signal of the authorities’ commitment to avoid a premature withdrawal of policy support, which is welcome, but lack of information about the specific conditions that would trigger withdrawal complicates communication and could add to uncertainty.
Prior to embarking on any new spending, it would be important to ensure its composition achieves well-defined objectives, including enhancing long-term growth. The federal government’s commitment to spend up to 4 percent of GDP over the next three years to support the recovery needs further justification. It has stated that the additional stimulus will be designed to provide the support the economy needs to operate at its full capacity and to stop COVID-19 from doing long-term damage to output. In this context, it is essential that the strength and durability of the recovery is evaluated against these objectives, as well as the government’s broader policy agenda to boost long-term growth, before a commitment to a significant new spending initiative is made. While the government still has some fiscal space, the additional spending, if deemed unjustified, could weaken the credibility of the fiscal framework.
The federal government needs to elaborate and clearly communicate its medium-term fiscal objectives. While the federal fiscal support provided is well justified and more support may be needed as the pandemic wanes, fiscal risks have clearly risen. Commitment to a well thought-through debt anchor supported by a well-understood operational rule, or the regular publication of longer-term fiscal projections that clearly illustrate fiscal sustainability, would go a long way towards ensuring that credibility in the fiscal framework is maintained over the medium term. Fiscal objectives should also be clearly communicated at the provincial level, especially in those provinces with wide deficits and high levels of debt.
The central bank should continue to clearly communicate its strategy for both maintaining and eventually withdrawing policy support. Current monetary policy settings are well-aligned with the needs of the economy. Scaling back asset purchases and gradually lifting the policy rate to its estimated natural rate once the economy has recovered will promote financial stability and help to create policy space for the next downturn. Clear communication about future policy intentions will be key to managing expectations during the recovery.
Financial sector support should also be gradually phased out as the effects of the pandemic fade. While current macroprudential policy settings are broadly appropriate, policy tightening should carefully balance short-term risks against longer-term macro-financial vulnerabilities. Policy should help to mitigate a broad-based and persistent buildup of leverage and address vulnerabilities in the housing market.
Beyond the pandemic—supporting sustainable and inclusive growth
Structural challenges that existed prior to the pandemic remain. Canada still needs to boost its productivity, support productivity-enhancing investments, and diversify beyond traditional sectors, including oil. Cutting regulatory barriers, reviewing the tax system to improve efficiency, and facilitating internal and international trade should remain on the list of key priorities. The federal government’s “build back better” plan aims to foster an inclusive recovery by investing in training and skills, empowering women and minorities, and creating opportunities for vulnerable groups.
While this is a welcome step, any new spending should also be evaluated against the government’s broader policy objectives, including its desire to increase the productive capacity of the economy. Moreover, the federal government’s emphasis on housing affordability is key for sustainable and inclusive growth, and should be supported by policies that focus on expanding the supply of housing.
Canada has pledged to become emissions neutral by 2050 and is implementing strong policies in line with this goal. The centerpiece is a requirement that provinces and territories implement a carbon price (or equivalent measures) rising to CAN $170 per ton by 2030. Energy-intensive, trade-exposed firms are covered by an output-based performance standard (OBPS). Carbon pricing is the most efficient policy for reducing emissions while returning the revenues to households in transparent tax relief helps with acceptability.
The authorities could consider reinforcing mitigation incentives in sectors that are difficult to decarbonize through pricing alone (e.g., transport, buildings, forestry, agriculture) with feebates—revenue-neutral sliding scales of fees/rebates on products with above/below average emission rates. A medium-term transition from the OBPS to a border carbon adjustment (BCA) could be considered. At the global level, Canada’s carbon price floor could be a valuable prototype for an international carbon price floor arrangement among large emitting countries.
Welcome progress has been made towards implementing recommendations from the 2019 Financial Sector Assessment Program. Notably, information sharing and collaboration among financial oversight authorities has been enhanced through the establishment of the Systemic Risk Surveillance Committee in 2019. Going forward, it would be important to address other recommendations, including the enhancement of regulatory capital requirements for banks’ mortgage exposures, which remains relevant amid continuously tight housing market conditions, and, in the near term, pandemic-related risks, which could affect the ability of households to service elevated levels of debt.
