Questions remain following fiscal snapshot

Federal finance minister, Bill Morneau, put a huge price tag on the Covid-19 pandemic yesterday — an exercise that left economists wondering just how that price is going to be paid.

In its “fiscal snapshot,” the federal government announced that it’s expecting the deficit to balloon to $343.2 billion this year, above even the highest private forecasts (which topped out at around $300 billion).

An avalanche of spending to combat the effects of the pandemic, coupled with the negative effects of the economic turmoil on government revenues, is driving the inflated deficit.

The government outlook is underpinned by the expectation that GDP will drop by 6.8% this year, before rebounding by 5.5% next year.

In the immediate aftermath of the update, bond markets recoiled.

“Bond traders choked on higher than expected Canadian debt issuance volumes,” said Scotiabank Economics — noting that bond markets sold off largely following the news of the higher-than-expected deficit.

While the specific numbers that the government is working with was news to the Street, the underlying dynamics were not — the pandemic has been devastating for the economy and government finances — the big question though is where we go from here.

“This fiscal snapshot leaves almost as many questions unanswered as it [answers],” said BMO Economics in a research note.

“For example, who will ultimately pay for this deficit, and how? What will happen when massive support programs expire? What will the next phase of fiscal policy look like? Will borrowing costs start to rise, especially after a credit-rating downgrade?” BMO noted.

For now, the answers to these questions are contingent on the path of the virus — namely whether a second wave will happen, leading to another round of economic damage.

“Fundamentally, Canada’s economic recovery hinges on its ability to effectively keep Covid-19 transmission down according to the snapshot,” Scotia said.

“Its outlook focuses predominantly on pandemic-related downside risks in an environment where there is no shortage of other risks including various geopolitical and trade tensions.”

“The good news for Canada is that the incidence of new Covid-19 cases is declining, strict social-distancing measures are being gradually lifted, and businesses are starting to reopen,” DBRS Morningstar said in a report on the update.

“However, in the absence of a vaccine, there is the possibility of renewed outbreaks, which could ultimately deepen the recession and dampen the prospects for recovery,” it warned.

Indeed, RBC Economics noted that the government’s update “acknowledged that any material worsening of the virus outlook will pose a significant risk to the government’s bottom line. It also left the door open for more recovery spending even after the virus is contained, to help manage the longer-term consequences of the crisis.”

DBRS said that the longer-term economic consequences “are difficult to discern at this stage, but it may be possible that evidence of structural damage could emerge as we move closer to the fourth quarter and into 2021.”

For now though, the economic outlook remains decidedly uncertain. As a result, “fiscal policymakers will likely need to adapt to conditions as they evolve,” DBRS said.

“Much will depend on the durability of the shock, as well as how quickly and efficiently the economy can reallocate labor and capital resources in the post-pandemic environment. Fiscal policy will likely remain supportive as the economy recovers, but the scale and design of that support still needs to be defined,” it said.

The government’s planned fall update, and next year’s federal budget, will be the next major opportunities for the government to set out its fiscal strategy.

“At this stage, panic is not warranted, but neither is complacency,” said BMO. “Clearly, when the economy is convincingly in the recovery phase, a path to fiscal sustainability will need to be outlined, particularly when the Bank of Canada begins winding down its current extraordinary support measures.”

For bond markets, the next big data point will be the Bank of Canada’s policy decisions next Wednesday, which Scotia said will also feature “its first attempt at a full suite of forecasts during the Covid-19 pandemic.”