Mark Carney emphasizes fiscal discipline in wake of U.K. crisis and Canada’s march toward recession

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Former Bank of Canada governor Mark Carney says Canada is heading toward a recession and that fiscal discipline will be “imperative” as policy makers enter a period of challenging trade-offs between promoting economic growth and taming inflation.

In the near-term, rising interest rates and slowing global economic activity make “at least a few quarters of negative growth in Canada” likely, Mr. Carney told the Senate Committee on Banking, Commerce and the Economy on Thursday.

Looking further ahead, the world economy is entering an era that will be defined by higher interest rates, more persistent inflation and greater volatility in financial markets, he said. That means higher borrowing costs and less available capital for businesses, as well as trickier policy choices for governments and central bankers.

“Sound money and credible fiscal policy will be rewarded. But mistakes will be punished and no one’s really going to be exempt,” he said.

Mr. Carney, who is vice-chair and head of transition investing at Brookfield Asset Management, joins a growing number of private-sector forecasters – including economists at the Royal Bank of Canada, Bank of Montreal and Bank of Nova Scotia – who predict a downturn in Canada next year.

The September inflation numbers, published on Wednesday, reinforced this view. Consumer price index inflation fell slightly, to 6.9 per cent, but price increases affected a broader range of products and services, increasing the odds that the Bank of Canada will announce a rate hike of another 75 basis points next week. The central bank is rapidly increasing borrowing costs and intentionally slowing economic activity in a bid to get prices under control.

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“I think a recession is most likely globally. And most probable in Canada,” Mr. Carney said. “I would put it this way. I’m afraid it’s a bit like air travel these days: We know where we’re headed, we just don’t know when we’re going to get there.”

In this deteriorating economic environment, Mr. Carney said politicians and bureaucrats need to make sure that monetary and fiscal policy are not working at cross-purposes. He pointed to the economic and political turmoil in Britain as an example of poor fiscal policy management and a warning about the challenges policy makers face in a more volatile economic environment.

Mr. Carney, who was Bank of England governor from 2013 to 2020, spoke hours after Liz Truss announced her resignation as prime minister of the United Kingdom. Her six-week term was defined by a currency and bond market rout that followed her government’s announcement of tax cuts that would be funded by new government borrowing.

Many economists thought the tax cuts would add to inflation at a time when the Bank of England was raising interest rates aggressively in an attempt to regain control of prices. Bond traders reacted by dumping U.K. government bonds. This caused a sharp move in bond prices and yields, and ended up squeezing U.K. pension funds whose investment strategies did not anticipate such large and rapid movements.

The Bank of England had to intervene to prevent a fire sale of government bonds. This put the central bank in an uncomfortable position: It was selling bonds to push up interest rates, while also buying them to prevent liquidity problems at pension funds from spiralling into a broader financial crisis.

“The experience in the U.K. underscores that, in an environment of tightening monetary policy, there will be rising tension between various macroeconomic objectives,” Mr. Carney said.

“So in the U.K., it wasn’t just fiscal policy and monetary policy objectives at cross purposes, [there were] tensions between financial stability and price stability, which saw the Bank of England both selling gilts, government bonds, and buying them.”

Mr. Carney, who has endorsed the Liberal Party and who is often mentioned as a potential Liberal leader, said the Canadian government was taking the right approach to fiscal policy, with relatively small and targeted supports for low-income Canadians affected by inflation.

Last month, the government announced a $4.6-billion package that included new payments to uninsured parents to cover their young children’s dental costs, a doubling of the GST credit and a boost in rent supports.

Mr. Carney said the size of the package relative to the size of the Canadian economy would not be “decisive” in terms of affecting inflation. However, he cautioned that too much fiscal support could add to inflation over time. This echoes Bank of Canada governor Tiff Macklem, who said last week that the federal government’s recent measures were not “consequential” from a macroeconomic perspective.

When you add in provincial government stimulus measures, however, fiscal policy does start to affect inflation and the direction of monetary policy, according Scotiabank’s chief economist, Jean-François Perrault, and director of modelling René Lalonde.

“As designed, this fiscal support has the unfortunate impact of blunting central bank efforts to fight inflation and may ultimately require higher interest rates to lower inflation,” Mr. Perrault and Mr. Lalonde wrote in a note to clients this week. They estimated that federal and provincial fiscal measures would require the Bank of Canada to raise interest rates by 25 basis points more in the coming quarters than would otherwise be needed.

While Canada is unlikely to avoid a downturn, Mr. Carney said the country is likely to fare better than many of its peers, thanks to its robust labour market, close ties with the United States and strong financial system.