With inflation raging at levels not seen in more than 30 years, attention has turned to the different ways in which the Bank of Canada and the government might contribute to taming it.
Specifically, it has been suggested that the government, which continues to pump out spending at a torrid rate, has been somewhat south of helpful in this regard. That’s true, though perhaps not quite in the way that it has been presented.
The bank’s contribution is relatively straightforward. If money has become too cheap and plentiful, it is to make it dearer and more scarce. Hence the recent sharp rises in interest rates, together with the gradual unwinding of the program of government bond purchases initiated during the pandemic.
That, however, is the easy part. No one should doubt that the bank can get inflation back down to the 2-per-cent range that is its target. The only question is how long it will take, and at what cost. That will depend, crucially, on how high people think inflation will stay, and for how long: on expectations of inflation, as the phrase has it.
If people believe the bank when it says inflation will shortly drop back to 2 per cent, they will adjust their own wage and price demands accordingly. If, on the other hand, they expect high inflation to persist, it will take a harsher and more prolonged dose of monetary tightening to persuade them. Or in other words, a recession.
The bank’s other main task, then, is clear: it is to scare the pants off people. If people think the bank is so serious about curbing inflation that it is willing to risk a recession to do so they will be more likely to adjust their demands in advance of the actual event. That’s right: The more people expect a recession, the less likely we are to have to endure one.
This is the “heartless bastard” theory of monetary policy. Unfortunately, today’s generation of central bankers were at some pains until lately to persuade people they were not so heartless as all that – that they were equally concerned with inclusion, and climate change, and other good causes.
Well, listen to them now. The sharp increases in interest rates of late have been accompanied by even sharper rhetoric. The Bank of Canada promises to act even “more forcefully” in future if need be. The Federal Reserve pledges more “pain” to come. Each speaks of its single-minded resolve to bring inflation down. Neither speaks of anything else.
What is the government’s role in all this? Mostly, it is to stay out of the way: To do nothing that would undermine the credibility of the bank, or otherwise hinder its efforts. At this undemanding task it has largely failed.
There are three things the government could be doing. One is to back the Bank of Canada to the hilt: To make clear that when the bank vows to do whatever it takes to get inflation down, it has the full support of the government. Yes, it’s doing that now. But it was only last fall that a lot of extraneous language was inserted in the bank’s mandate, at the same government’s behest.
Two, it could get control of its spending. As we’ve seen, that has not been forthcoming. This is sometimes presented as if government spending were itself helping to fuel inflation. But it’s not clear that fiscal policy in a small, open economy has that kind of effect on prices, any more than it does on real output.
Government spending is more likely to affect the composition of demand than the level. Only if the central bank accommodates that spending, that is by supplying more money, does it result in higher spending in the aggregate. Otherwise it just crowds out private spending.
Which is what is happening now. As a recent report by economists at the Bank of Nova Scotia put it, if public spending cannot be reduced, private spending must be reduced all the more (“the output losses that the BoC must engineer to rein in inflation are falling disproportionately on the private sector”), by means of higher interest rates than would otherwise be required.
Three, the government could implement measures to improve the efficiency and flexibility of the economy – its ability to supply goods and services in line with the demand. The more dynamic this “supply side” response, the more a given increase in demand will translate into higher output, rather than higher prices – and the less output will contract, in the reverse.
The government has only latterly begun even talking about this. It’s a start. But it will have to back this with much more in the way of policy if it wants to be regarded as a help, and not a hindrance, in the battle against inflation.
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Andrew Coyne