Trudeau's return to power with big spending plans could fuel Canada's hot inflation

Prime Minister Justin Trudeau risks further fueling Canada's hot inflation if he presses ahead with spending plans outlined during the election campaign, which could pressure the Bank of Canada to hike interest rates sooner than planned.

Trudeau's Liberals have pledged C$78 billion ($61.6 billion) in new spending over five years, about 4% of gross domestic product. That would be in addition to the C$101 billion in extra spending over three years passed in a budget earlier this year.

Provisional election results show the Liberals coming away with another minority government, forcing them again to work with opposition legislators such as the left-leaning New Democratic Party, which has its own spending priorities. 

"When you start to see this sort of stimulus hitting the economy ... we think it could prompt the Bank of Canada to respond," said Tony Stillo, director of Canada economics at Oxford Economics.

"We think the slack in the economy could be absorbed quickly, by early next year."

Money markets have in recent weeks priced in an additional 14 basis points of tightening by the central bank over the coming year, expecting a rate hike as soon as next July.

The BOC declined to comment.

Extra spending could add to inflation pressures by reducing slack in the economy. In August, Canada's annual inflation rate accelerated to its highest level in 18 years at 4.1%, well above the Bank of Canada's 1%-3% target range. 

The central bank has been cutting its bond purchase program but is waiting for economic slack to be absorbed before considering lifting interest rates from a record low of 0.25%. A return to full capacity would happen in the second half of 2022 in its latest forecast.

SUPPLY SIDE

Trudeau has repeatedly dodged questions about the inflationary impact of his spending plans, saying his focus was on helping Canadian families and those struggling with the pandemic. Early in the campaign, he told reporters "You'll forgive me if I don't think about monetary policy."

But evidence that supply chain hurdles and labor shortages are lifting inflation could indicate that extra stimulus is not what the economy needs right now.

The economy is constrained by supply-side issues rather than too little demand, said Doug Porter, chief economist at BMO Capital Markets. With the extra fiscal spending, the risks to inflation "are tilted to the high side."

Canada's economy is expected to rebound after it unexpectedly shrank in the second quarter and employment has climbed to within 1% of pre-pandemic levels.

"The economy has come back, employment has come back," said Pedro Antunes, chief economist at the Conference Board of Canada. "There's an awful lot of savings and there is an awful lot of profits right now in the economy with these support programs."

($1 = 1.2656 Canadian dollars)