Abstract
The government’s strong monetary and fiscal policy framework, as well as the structural reforms introduced, have enabled the Canadian economy to respond flexibly to recent shocks and laid a solid foundation for recovery. Macroeconomic policies should remain supportive, with fiscal policy continuing to focus on sustained debt reduction and structural reforms geared toward boosting productivity. Canada’s commitment to exchange rate flexibility has been helpful in facilitating the adjustment of global macroeconomic imbalances. Ensuring that regulatory and other policies support productivity, growth remains a key long-term challenge.
1. This note reports on recent macroeconomic and policy developments since the staff report was issued. These developments do not alter the thrust of the staff appraisal.
Recent economic and financial market developments
2. Recent indicators point to a slower-than-expected pick up in activity in the fourth quarter of 2003. GDP was essentially flat in November, following only 0.1 percent growth in October. The November trade surplus also fell, owing to continued declines in exports of autos and capital goods, while imports grew strongly.
3. Nonetheless, household and labor market indicators remain generally favorable. Although retail sales fell ½ percent in November, sales excluding autos rose by ¾ percent, and housing activity remained strong with the construction sector posting robust gains. Employment has continued to rise in recent months, accumulating gains of 50,000 new jobs in both December 2003 and January 2004. The majority of job gains were in full-time work, with private sector employment accounting for most of the increase. The unemployment rate edged down to 7.4 percent, as the labor force participation rate reached new record highs in December.
4. Inflation remains subdued. The headline CPI edged up 0.1 percent in December, and the Bank of Canada’s core measure was up 0.2 percent. However, the base effects of December 2002 electricity price rebates in Ontario caused the year-over-year headline and core inflation rates to rise to 2.0 percent and 2.2 percent, respectively.
Monetary policy
5. On January 20, the Bank of Canada lowered its target for the overnight rate by 25 basis points to 2½ percent. In the accompanying Monetary Policy Report update, the Bank noted that the strength of the Canadian dollar and signs of larger-than-earlier anticipated economic slack meant that additional monetary stimulus was required to support demand and return inflation to its target. In the update, the Bank scaled back its growth projection to 2¾ percent in 2004 and 3¾ percent in 2005, with the output gap expected to close only by the third quarter of 2005, and core inflation to fall below 1½ percent in early 2004, before returning to the 2 percent target by end 2005.
6. Financial markets appear to be pricing in a further cut in the overnight rate. Three-month treasury bill yields have remained about 25 bps below the Bank of Canada’s overnight rate since the January 20 interest rate announcement in the context of the broader strengthening of the U.S. dollar in recent weeks—the Canadian dollar has fallen by about 4 percent against the U.S. dollar since mid-January.
Fiscal and other policy developments
7. The January Throne speech outlined the principal policy priorities of Prime Minister Paul Martin’s government, which included the following commitments:
To assist local governments in funding infrastructure investment, with the government providing municipalities a rebate of their payments of Goods and Services Tax, at a cost to the federal government roughly of % percent of GDP annually.
To preserve the sustainability of the health care system and work with the provinces on “the necessary reforms and long term sustainability of the health care system.”
To achieve the Kyoto Accord goals for greenhouse-gas emissions and increase funding for other environmental initiatives, including a ten-year, $3.5-billion plan to clean up contaminated sites (which has already been included in earlier budget projections.)
To promote job training and higher education, including by calling for an overhaul of the Canada Student Loans program, creating new grants for postsecondary education, and expanding the benefits of education savings plans, especially for lower-income families.
8. In the period leading up to the 2005 Budget, the government has re-affirmed its commitment to preserving fiscal surpluses. In late December 2003, the new Finance Minister announced a freeze on large capital projects and limits on public sector employee pay rises, and introduced a Cabinet-led review of government program spending. In recent speeches, the Minister cautioned that the fiscal position will be under pressure both because of the impact of the economic situation on revenues and the need to fund new priorities, but he has stressed the government’s continued commitment to fiscal surpluses and debt reduction.