Unwinding pandemic policy measures will ease foot off inflation gas pedal

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In the raging debate over Canada’s worrisome inflation buildup, there is a camp that believes public policy makers are in denial about their own role in the rise of price pressures. They may have a point.

But if they’re right, they can also take heart. Those public policies are about to reverse course – easing the public foot from the inflation accelerator.

Pandemic-related measures on both the fiscal (government spending) and monetary (Bank of Canada) sides are poised to recede in the coming weeks, removing a significant amount of policy stimulus from the economy. Turns out policy, like a lot of other contributors to the current inflation picture, can also be transitory.

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Friday’s surging employment numbers for September – a jump of 157,000 jobs, bringing total employment above its prepandemic level for the first time – have cemented expectations that the Bank of Canada will further cut government bond purchases under its quantitative easing, or QE, program, when its senior officials issue their next policy decision on Oct. 27. That cut will likely reduce the program to about $1-billion a week – half of its current size, and a far cry from the program’s original $5-billion weekly.

It’s an important milestone. The anticipated cut will effectively move QE policy into neutral territory, with the bank merely replacing the amount of its government bond holdings that reach maturity and thus fall off its books each week. That implies that QE itself will become neutral – no longer a force influencing market interest rates lower as a means of stimulating economic activity.

When the Bank of Canada launched the QE program in March, 2020, at the peak of pandemic-related economic and market fears, one of its biggest fears was not inflation, but deflation – a dreaded downward spiral that could tip the economy into a full-on depression. The policy was very consciously designed to lean against those forces and avert the much worse fate.

“Picture the pandemic creating a giant deflationary crater in the middle of the economy; it takes what looks like inflationary policies to offset it,” then-Bank of Canada governor Stephen Poloz explained in a May, 2020, speech.

“By providing that exceptional stimulus, that’s helpful in getting inflation back to the target faster,” current Governor Tiff Macklem said in an interview with The Globe and Mail last spring. “If that means we go a little over the [2-per-cent inflation] target for a period, that is definitely a risk worth taking.”

This is important to keep in mind, even as Mr. Macklem continued last week to point his focus away from policy and toward the “transitory” factors from the pandemic that are fuelling inflation: supply chain bottlenecks and abnormal year-over-year price comparisons. The Bank of Canada saw its extraordinary monetary policy measures from the start as explicitly and intentionally inflationary. The withdrawal of those measures, then, just as clearly represents a reduction of inflationary pressures. Mr. Macklem may have “transitory” on his lips, but he’s turning down the monetary policy heat under the inflation burner.

At the same, the fiscal heat is also about to dial down.

Stephen Brown, senior Canada economist at independent research firm Capital Economics, estimated in a report last week that the wind-down of federal pandemic support programs over the next couple of months will remove the equivalent of more than $40-billion, annualized, of government contribution to the economy. Even with Ottawa considering extending some wage and rent relief for a few sectors hardest hit by restrictions in the current Delta variant wave of the pandemic, the scale looks likely to be tiny compared with the programs that are ending.

“Together, this implies a fiscal contraction of 1.7 per cent of GDP over the space of just two months,” Mr. Brown said. “Whether one thinks the winding down of these programs is justified or not, this is still a big hit to the incomes of households and firms.”

While that certainly poses a drag on GDP growth in the coming months, it also represents a withdrawal of fiscal stimulus that has unquestionably contributed to the current inflation situation. The easing of government-funded demand may mean a moderating of the recovery, but that may be exactly what the inflation doctor ordered right now.

Still, the big guns for leaning policy against inflation – namely, Bank of Canada interest-rate hikes – remain silent. The Bank of Canada has been steadfast that it won’t raise rates until the economy returns to full capacity, and even the most optimistic of forecasters see that as more than six months away.

Bank of Nova Scotia economist Derek Holt suggests that maybe the central bank needs to rethink that – and that maybe it should look back at its original deflation motivation as a guide.

“Extreme stimulus was put into place at the start of the pandemic because of deflation fears, because vaccines were nowhere in sight and because fiscal policy makers were fair-weather friends,” Mr. Holt said in a research note Friday.

“Standing here today, such conditions for maintaining extreme monetary policy stimulus are gone.”

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