Canadian Government Budget Deficits & Interest Rates

Source: FactSet

We are approaching the time of year when the Canadian Government announces its annual budget. This year, we are hoping that the COVID pandemic will be less of a drain on government coffers, and we are interested to see how the Minister of Finance plans to balance the budget. However, is balancing the budget sufficient since total government debt has increased to a level many would not have thought possible a few short years ago? How is the Canadian Government going to pay down the debt without strangling the economy and, what will happen to interest rates?

As depicted in the chart above, prior to 2008, large monthly or quarterly deficits were generally followed by a series of positive months. This was not the case immediately after the financial crash of 2008 however, starting in 2011, there were some positive months. Since January 2020, we have not had a single positive month and the deficits have consistently been at the highest levels experienced prior to January 2020.

Normally, the first line of attack when trying to pay down debt, is to raise taxes. This is likely one of the solutions that the government is examining. However, this is going to be difficult when one is dealing with a population already struggling under the strain of higher inflation and higher interest rates.

The next line of attack is likely to be a major cost cutting exercise on behalf of the Federal Government. The most likely target for such cost cutting will be provincial governments, who have their own debt problems to worry about. If provinces need to start cutting costs, they will most likely look towards reducing civil servant payrolls, infrastructure, health, and housing. Politically, these will be very unpopular, and the provinces will try to blame the federal government.

Lastly, many governments would love to be able to inflate their way out of the problem and, herein lies the answer to the question of how diligently the central banks around the world will fight inflation. Given that the bond markets, which historically provided a governance function on excessive government expenditure, are now strongly influenced by central bank policies and bond purchases, it is unlikely that bond markets will stand in the way of governments inflating their way out of a debt problem. This would imply that the market is over-reacting to potential interest rate hikes and, rates will not rise as the market anticipates.

Which option will the government in Ottawa choose? We will need to wait for the budget to find out.

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