Wednesday's Bank of Canada rate increase reminds us once again that the era of cheap money is over not just for consumers and business but also governments. One of the notable features of the pandemic response in Canada was the enormous amount of federal fiscal stimulus injected into the economy. Federal spending rose from $363 billion in fiscal 2019-20 to reach $639 billion in 2020-21 – an increase of 73 percent. It then began to subside going down to $480 billion as reported in Budget 2023 but is set to resume an upward trend and reach $556 billion by 2027-28. As of the 2022-23 fiscal year, federal spending is 37 percent higher than going into the pandemic meaning an average annual increase in spending of about 12 percent. This has been funded by deficits which in turn have increased the federal net debt dramatically going from $813 billion in 2019-20 to $1.3 trillion by 2022-23 and is expected to reach just over $1.4 trillion by 2027-28.
The long-term implications of this spending and debt surge are of course debt service costs. As a result of recent interest rate increases, they are about to become in nominal terms the largest, they have ever been. Using data from the federal Fiscal Reference Tables and Budget 2023, Figure 1 plots both the total annual amount of federal debt charges paid as well as the annual percent increase for the period 2000 to 2022 and then as forecast until 2028. What is evident at a glance is that until 2021, annual debt charges had been on a downward trend falling from nearly $44 billion in 2011 to $20.4 billion in 2021. Since then, they have soared growing 20 percent in 2022 and forecast at 41 percent and 27 percent growth in 2023 and 2024 respectively before subsiding. Indeed, by 2028, annual debt service costs are anticipated under the current forecast to reach over $50 billion which surpasses even the peaks reached in the 1990s.
Now of course, as a share of total federal government spending, these debt charges may seem less alarming as at less than ten percent of total expenditure, they are modest relative to peaks of nearly 30 percent or more in the 1990s and 1930s. However, it should be noted that the share of total federal government spending going to debt service more than doubled between 2021 and 2023 rising from 3.2 to 7.2 percent and is expected to keep rising to just over 9 percent by 2028. Nothing to worry about you might think? However, it all depends on what happens to interest rates. The fact remains that not surprisingly there is a strong correlation between the growth rate of federal debt charges and the effective interest rate on the net federal debt.
Figure 2 plots the annual percent change in federal debt charges against the effective interest rate on the net debt since 1867 (calculated as debt charges divided by net debt) using data from A Federal Fiscal History, the federal Fiscal Reference Tables and Budget 2023. With a linear trend fitted, there is a definite positive correlation that has a bigger impact than you might think. On average, a one percentage point increase in the rate of interest is associated with a nearly two percent increase in debt charges. Given such sensitivity, it is not a surprise that debt charges have doubled since 2021. And the current situation is anything but average given the enormous stock of nominal debt meaning that even with the staggering of long-term government bond debt issue, small interest rate increases can have large increases in government debt interest costs. Moreover, with the anemic real GDP growth forecasts and an increase in interest rates, the long-term sustainability of the federal fiscal position becomes more of an issue. We are in for interesting times.
