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Canada's fiscal spending moves out of step with overheating economy

FILE PHOTO: Inflation continues to raise concerns in Toronto

(This March 29 story has been refiled to fixe typo in economist's name in paragraph 7)

By Fergal Smith and Molly Cone

TORONTO (Reuters) - Canadian Finance Minister Chrystia Freeland's promise of a fiscally prudent budget in the face of high inflation has disappointed some strategists who had hoped for spending restraint from the Liberal government.

Increased spending in the budget leaves the government with less in reserve to deal with a possible economic downturn and it could forestall a shift to interest rate cuts by the Bank of Canada, analysts said.

The worry is that the deficit, estimated at C$43 billion ($31.7 billion) in 2022-23, or 1.5% of GDP, is wider than it should be at this point of the economic cycle, with the economy running hot, unemployment at a near record low and inflation elevated, analysts said.

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"A lot of folks would have liked to have seen a little bit more fiscal restraint ... just to reserve spending power in case we do go into a deeper recession than people are predicting," said Francis Fong, senior economist in charge of ESG research at TD Economics.

Freeland repeatedly promised in recent weeks that the budget would not make the Bank of Canada's job harder to fight inflation, but the government projected C$43 billion of net new spending, while the six-year forecasting horizon no longer shows a return to balance.

Earlier this month, the central bank paused its tightening campaign after eight consecutive rate hikes to tackle price pressures. Money markets are betting it will shift to cutting interest rates over the coming months after recent stress in the global banking sector raised prospects for a credit crunch.

"It probably puts a little bit of impetus on the Bank of Canada to think about not cutting rates if they were thinking about cutting rates towards the end of 2023," said Jules Boudreau, a senior economist at Mackenzie Investments.

Initiatives aimed at accelerating the transition to a low-carbon economy were welcomed by economists.

Still, green investment should have been anticipated and planned for, while program expenses as a share of GDP, estimated at 15.9% in 2023-24, remain far above the pre-pandemic level of 14.6%, Cynthia Leach and Josh Nye, economists at RBC, said in a note.

"(The budget) delivers mostly against expectation in the sense that it delivers yet another fiscally expensive budget," said Rebekah Young, head of inclusion and resilience economics at Scotiabank.

"Some big ticket items in there, most of which were expected, but then a little bit of a slippery slope with more added on."

The budget projects that economic growth will slow to 0.3% this year from 3.4% in 2022.

As revenue growth slows, new policy items would not only threaten progress on reducing deficits "but could give a push to inflation in what is for now a fully employed economy," Avery Shenfeld, chief economist at CIBC Capital Markets, said in a note.

Taking account of tax hikes and other offsets in the budget, Shenfeld doesn't expect the overall implication for inflation to be enough to sway the BoC.

($1 = 1.3569 Canadian dollars)

(Reporting by Fergal Smith and Molly Cone; Editing by Denny Thomas and Jonathan Oatis)