As the Bank of Canada raises interest rates, governments need to help by increasing the economy’s capacityJustin Tang/The Canadian Press
Jeremy Kronick is director of monetary and financial services research at the C.D. Howe Institute.
When everyone understands the role they play, this leads to better public policy. For our monetary and fiscal authorities, this means central bankers ensuring a stable value for the currency they oversee, and governments creating the conditions for strong economic growth.
Unfortunately, we lack that in Canada right now, with inflation as high as it has been in 40 years, and an economy potentially heading toward a recession. The Bank of Canada is working hard to bring down inflation. If governments were indeed boosting the economy’s potential, it would make the bank’s job a heck of a lot easier.
With mandates that target inflation – and ones that target maximum sustainable employment as well, such as that of the U.S. Federal Reserve – central banks tend to react primarily to two things: the deviation of inflation from its mandated target rate – 2 per cent in Canada’s case – and something called the output gap.
This output gap is the deviations of actual output from the economy’s potential – that is, the amount of goods and services the economy is producing currently versus how much it can produce at full capacity. The output gap is a measure of whether the economy is running too hot or too cold.
If inflation is above its target and/or output is above its potential, central banks increase their policy interest rate to cool things down; if the reverse is true, they decrease their policy rate to stimulate things.
Central banks focused on deviations from a baseline are aiming for stability. They stabilize inflation and the economy when it is above or below capacity. That’s what the Bank of Canada’s policy rate does, and with inflation well above its target today, we are seeing rate hikes at a pace and size we haven’t seen in a generation.
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While it might be tempting to let the economy run hot, we have seen the damage inflation can do beyond just the devaluing of the money in our pockets: strikes, bad investment decisions from a misreading of prices, and tax distortions, to name a few.
We may or may not be nearing the end of this tightening cycle, but there are lessons either way for governments on where to focus their attention to take some of the pressure off the central bank – to do what governments in Canada are currently not doing.
Remember that the central bank is hiking its overnight rate because the economy is running too hot: economic growth exceeds the economy’s potential – what can be produced at the maximum sustainable level of employment.
To bring growth and the economy’s potential back in line there are two options: decrease economic growth (which is what the rate hikes are doing) or increase our economy’s potential. The latter sounds much better than the former, and that’s where governments come in.
We cannot directly measure an economy’s potential. But what we can do is estimate it by looking at other important factors, including trends in the labour market, e.g. how many hours people are working, and how much businesses are investing in machines and equipment to boost productivity.
The focus for governments should be on policies that increase the economy’s productivity. When you increase productivity, inputs become cheaper, which leads to cheaper output and lower prices. So, as potential output increases, the output gap closes on its own, inflation comes down and smaller interest rate hikes are needed.
What are some of these productivity-enhancing policies? There are many, but one massive elephant in the room is Canada’s need to boost growth in our small and medium-sized enterprises (SMEs).
While it is a nice soundbite that 90 per cent of our private labour force works in SMEs, the number is 47 per cent in the United States. What Canada is not doing is growing our SMEs into the kinds of large enterprises that will close the productivity gap between us and our neighbours to the south.
Policies in other countries provide a template Canada can follow to improve our SME growth story. In 2010, the U.S. passed the Small Business Jobs Act, which exempted from taxation capital gains realized on the sale of certain shares in small businesses that were held for at least five consecutive years.
In Israel, SMEs that have achieved a successful liquidity event (e.g., an initial public offering) can reinvest those proceeds into innovation and pay no capital gains tax as long as they do it within two years.
Other examples exist, and other policy levers exist, but movement in this direction will encourage greater innovation, productivity gains and increase the economy’s potential.
While the Bank of Canada is a Crown corporation, it is important to differentiate between the role a central bank plays in the economy and the job of fiscal authorities: The former creates the conditions for stability, the latter create the conditions for growth. When they work together you get a steady and sustainably growing economy. Sounds pretty good to me right about now.