INSIGHT ARTICLE  |  October 19, 2021

There are hard lessons to be learned from globalization and the response of policymakers to economic shocks and health crises. As much as those responses are well-intentioned, distortions in supply and demand could now threaten the economic recovery and have produced asset price bubbles that will need to be addressed as these crises unwind. Moreover, the combination of the property sector crisis in China, the showdown over raising the debt ceiling in the United States, and disruptions to the global supply chain are all contributing to volatility in global financial conditions and creating the environment for a slower pace of growth in Canada and around the world.

Unintended consequence No. 1

The first misstep was the lack of a consistent public health approach. This lack of disciplined policy underscored by the quick reopening of local economies and the U.S. withdrawing from the World Health Organization has given the coronavirus the time and means to mutate and spread. Now the recovery of the Canadian and U.S. economies is running into headwinds, first and foremost because the pandemic never really ended in all parts of the world. In addition, as we now exist in an interdependent world, with production in one place and consumption in another, the resurgence of the coronavirus outside the developed world is once more creating a supply crisis throughout developed economies. In its latest assessment, the Bank of Canada finds Canada's recovery to be choppy, with an abundance of uncertainty due to the fourth wave of COVID-19 infections and deaths. Though jobs have rebounded, the bank considers the recovery of the labour market to be uneven. (Statistics Canada attributes much of the latest increase in service-sector employment to the easing of public health restrictions in many jurisdictions.) Growth in the second quarter was weaker than expected, the bank said, as supply chain bottlenecks constrained manufacturing and exports. As such, consumption, business investment and government spending continued to fuel the recovery. Economists polled by Bloomberg have taken notice of the bottlenecks, halving their forecast for Canada's third quarter 2021 growth from a giddy annualized rate of 9 per cent down to 4.5 per cent. We suspect that with consumers unwilling or unable to purchase higher-priced goods, the negative impact on GDP will continue as long as the supply constraints exist. And because that will affect the profits of corporations, the stock market has become the canary in the coal mine. The U.S. S&P 500 equity market index lost nearly 4.8 per cent of its value during September, and the Toronto stock exchange lost 2.5 per cent.

RSM Canada Financial Conditions Index and financial conditions excluding commodities

Although the Bank of Canada noted in its Sept. 8 assessment that financial conditions remain highly accommodative the equity markets are now hinting at a reassessment of potential corporate profitability and overall growth during an extended supply chain crisis. Those factors have the potential to become a drag on financial conditions, with an increase in the risk (and cost) of investment limiting overall economic growth. The RSM Canada Financial Conditions Index is designed to show the level of accommodation in the financial sector, with positive values indicating a climate conducive for investment essential for a growing economy and negative values indicating higher-than-normal levels of risk being priced into financial securities. The index has drifted lower, from 1.0 to 0.6 standard deviations, indicating a reduced level of accommodation. This is mainly due to the diminished performance of equities and commodities. (The tapering in the commodity price component is due to base period effects after an initial upsurge in prices and to what anecdotal information tells us is a pause in the growth of demand for raw materials due to the bottlenecks.) Since the start of the year, the RSM index has indicated that the level of risk priced into financial assets has been consistently lower than normal. This reduced level of risk is a testament to preemptive actions by the Bank of Canada during the recent trade war and subsequent pandemic to foster the quick recovery of household spending and investment. These measures contributed to well-behaved financial markets after the initial collapse. Accommodative financial conditions may also reflect policy consensus across Canada's main political parties. Even the Conservative Party, which has traditionally been fiscally prudent, has accepted a more interventionist and activist role by the federal government to support recovery and address economic dislocations in the near term. While there are some wide disagreements on how each party plans to pay for this spending, the federal government's stance on the economy is not likely to change.

Unintended consequence No. 2

The second unintended consequence of government policy relates to the public's demand for single family housing in response to the public health crisis. That demand has been fueled by the Bank of Canada's accommodative interest rate policy. The central bank has said that it will keep interest rates at extremely low levels for as long as slack remains in the economy. But will the unintended consequence of that accommodation turn on itself? Have low interest rates created an asset bubble that will endanger the financial health of overextended households? Therefore, while financial conditions are far from being too exuberant, there are nonetheless outcomes that need to be addressed by the fiscal authorities. Arguably, the low interest rates are contributing to a housing crisis for low- to middle-income households. Consider that suitable and affordable housing is as much a necessary condition for economic growth as are the health and education of the labour force. The Bank of Canada recently noted that housing market activity pulled back from recent high levels. And long-term interest rates have remained higher than their pandemic lows and have recently shown signs of moving higher in response to inflation concerns and the prospect for higher economic growth. Whether that helps cool the housing market does not alter the fact that ordinary people can no longer afford to live close to their work.

Canada and U.S. 10-year yields

The takeaway The coordinated response by the fiscal and monetary authorities to the shocks of the trade war and the pandemic has been remarkably effective. Their moves have averted what could have been an economic disaster. And the peculiar nature of the pandemic has both exposed societal fractures and provided time for both policymakers and businesses to consider matters beyond the normal course of discussion. It would be nice to think the trauma of the last two years is over. But we live in a global economy, and the incidence of public health crises has accelerated. In this global financial system, the spillover effects emanating from Beijing or Washington are likely to affect the course of Bank of Canada and government policies.