Analysis shows Bank of Canada forecasts half a percentage point too high

TORONTO, Aug. 28, 2012 /CNW/ - Canadian governments will take a bite out of the country's real GDP growth in 2013, not boost it as forecast by the Bank of Canada, finds CIBC's latest Canadian Employment Insights Report.

"Just as we warned that the Bank was too optimistic in its initial 2012 call, its 2013 forecast also looks to be counting its government spending chickens well before they will be hatched," says Avery Shenfeld, chief economist at CIBC. "We examined projections included in the federal budget and those of the four largest provinces, adjusted to strip out transfers to households and capital amortizations, and added back capital spending. Our analysis points to yet another drop in real expenditures, with no major offset from planned tax reductions. We estimate that real government spending will decline by 0.9 per cent in 2013/14, only slightly less than the projected dip in the current fiscal year. On a calendar year basis, that points to a roughly 0.2 percentage-point drag on real GDP growth.

"That doesn't look like a big deal, until one contrasts it with the 0.3 per cent boost to growth in the Bank of Canada forecast. The result is that the Bank's forecast could be about 0.5 percentage points too high, enough to make the difference between growth being above potential, requiring interest rate hikes, or as in our forecast of 2.0 per cent growth next year, not fast enough to narrow the output gap and call for monetary tightening."

Mr. Shenfeld says that, at least to this point, Canada's economy has done well enough to make it prudent to sacrifice some growth in order to right the fiscal ship, and have the room to respond with stimulus should the economy take a new hit down the road.

He also notes that a longer term look at government spending suggests that we have yet to complete the full wind-down from the recession-related jump in government's role in the economy. Nominal government spending on goods, services and capital investment is running about 1½ per cent above its historical average share of GDP, and even further above where it stood in the last cycle. However, the federal and provincial governments are committed to additional spending cuts in an effort to reduce deficits.

"But there is still a significant pinch to economic growth associated with budget belt tightening," says Mr. Shenfeld. "To understand why the economy feels a bit sluggish now, it's more meaningful to compare the impact on growth from the swing from the typical historic growth rate in government spending vs. today's decline.

"Prior to 2011, the economy had spent many years enjoying the lift from a trend increase in government employment, purchases and capital spending. Had real government spending been advancing by 3 per cent, its average 1997-2007 pre-crisis trend, year-on-year GDP growth in Q1 2012 would have also measured 3 per cent, vs. the current 1.8 per cent."

The report notes that when it comes to the current 2012/13 fiscal year, nominal GDP growth—the best proxy for own-source revenue growth—hasn't quite lived up to expectations. In particular, related weakness in commodities has dampened the outlook for some resource revenues. However, for 2012/13, fiscal padding should more than compensate for the current year's economic hiccup, allowing federal and provincial budget balances to once again beat official targets.

"But fiscal 2013/14 is shaping up to be a taller challenge," adds Mr. Shenfeld. "We see Canadian real GDP limping ahead by just 2 per cent next year. So despite the stronger handoff from last year and the considerable padding built into the current year's targets, a lackluster growth outlook for 2013 could wash that benefit away in terms of the room for spending growth. That makes the existing, lean-and-mean two-year fiscal plans, as laid out in 2012 budget documents, a reasonable starting point for assessing how much further fiscal drag is in store for 2013, even if, as they say, plans can change."

While Mr. Shenfeld doesn't see the country's growth matching what the Bank of Canada has forecast, he does find that, compared to what is happening in other jurisdictions, Canada remains in an inevitable position. Serious concerns remain about the health of many economies with attention shifting to risks in Italy and Japan.

He also notes that even in Canada, there's a lot more attention being paid to the risks that the U.S. economy will tumble over a fiscal cliff than to the impact of fiscal restraint on the home front. "Having started from a combined federal/provincial deficit of only a third of that stateside, there's no equivalent threat of an outright recession being induced by cuts coming from Ottawa and the provinces. We'll get through our fiscal drag much sooner than the U.S. with a lot less pain in total."

The complete CIBC World Markets report is available at: http://research.cibcwm.com/economic_public/download/eiaug12.pdf

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SOURCE: CIBC World Markets