Although the federal government’s spending on COVID-19 support programs has made only a small contribution to the run-up in inflation, it has forced the Bank of Canada to raise interest rates in a more aggressive fashion than would otherwise have been needed, Bank of Nova Scotia economists say in a new report.
As Canada has grappled with the highest inflation rates in nearly four decades, there has been a great deal of debate about what is causing price growth, including the role that government spending has played.
About half of the increase in core inflation beyond the Bank of Canada’s 2-per-cent target since the end of 2019 can be attributed to global factors, such as lofty U.S. inflation, changes in currency exchange rates and higher commodity prices, the Scotiabank report says. Another 35 per cent of the inflation surge can be pinned on supply shortages.
The remainder – 15 per cent – is owing to domestic factors, mostly the federal government’s “welcome, but likely exaggerated” fiscal support for workers and businesses during the pandemic, according to the report, which was co-written by Scotiabank chief economist Jean-François Perrault and René Lalonde, the bank’s director of modelling and forecasting.
While Ottawa’s COVID-19 spending played a small role in driving inflation higher, it also created excess demand that the Bank of Canada is trying to curb by increasing the cost of borrowing, the Scotiabank economists argue.
The Bank of Canada has raised its key lending rate from 0.25 per cent to 3.75 per cent in a series of decisions this year. The next rate decision is on Wednesday. Financial analysts are split over whether the bank will hike by another 25 basis points, or opt for a larger 50-basis-point increase. (A basis point is 1/100th of a percentage point.)
Scotiabank expects a hike of 50 basis points, and is predicting that the increase will mark the end of the central bank’s current rate-hike cycle, amounting to a cumulative tightening of 400 basis points. Out of that, it estimates that up to 125 basis points were in response to demand created by pandemic support measures.
“These programs had a large and welcome impact on the economy,” the report says. However, “the economic and employment response of these programs created more inflationary pressures than would otherwise have occurred.”
To a large degree, the situation was unavoidable. When COVID-19 escalated in early 2020, Ottawa created several support programs on the fly, aimed at delivering quick financial assistance to ailing workers and businesses. Economists have largely applauded those initial moves for staving off disastrous outcomes.
But there is still dispute over whether those programs were too generous and lengthy. Household disposable income surged as the government funds were being disbursed, more than compensating for the loss of employment income amid layoffs. “The transfers received are just off the charts,” Mr. Perrault said in an interview. “It’s clear now that we did too much” with pandemic spending, he added.
A separate issue is fraudulent payments. The Auditor-General said on Tuesday that $4.6-billion in COVID-19 benefits were sent to ineligible recipients, and that an additional $27.4-billion should be investigated further.
Mr. Perrault said that, even if pandemic programs were perfectly designed, the economy would likely still have found itself in excess demand, though it would not have needed as forceful a response from the Bank of Canada.
Debates about the relationship between fiscal and monetary policy continue. The federal government and a number of provincial governments have announced new spending in recent months aimed at providing relief to people being squeezed by rising prices.
Quebec is sending cheques of between $400 and $600 to most people in the province, while Alberta recently announced that it would send $600 cheques to seniors, and one $600 cheque per child to families earning less than $180,000 a year. The federal government announced a $4.6-billion “inflation-relief” package in September that doubled the GST credit for low-income Canadians, boosted rent supports and included new payments to uninsured parents to cover their children’s dental costs.
Some of these measures have been criticized as counterproductive: They boost people’s spending power at the same time the Bank of Canada is trying to cool overall spending with higher interest rates.
Bank of Canada Governor Tiff Macklem was asked about the new federal government support measures at a parliamentary finance committee hearing last month. He said that they would not have a significant impact on inflation, but that governments do need to be mindful of not undercutting central bank efforts.
“Policies aimed at mitigating the effects of inflation on citizens really need to be targeted on the most vulnerable, and temporary while this is an inflation problem,” Mr. Macklem told MPs. “The price system works, and you have to let it work. That’s part of getting inflation back down. So you don’t want monetary and fiscal policy to work at cross purposes.”