Jeremy Kronick is associate director, research, at the C.D. Howe Institute.
A global pandemic that has crushed the economy. A stock market improbably rising in an economic downturn. Is it the job of the Bank of Canada to address this contradiction, and the inequality that arises?
Not directly, but the link between monetary policy and inequality is very real and affects the ability of the central bank to reliably hit its 2-per-cent inflation target.
In March and April, when we went into complete lockdown because of the COVID-19 pandemic, GDP fell more than 18 per cent, the largest two-month economic decline on record. A myriad fiscal policies were put in place, including household income supports, such as the Canada Emergency Response Benefit, and business supports, such as the Canadian Emergency Wage Subsidy.
The monetary policy response began with the Bank of Canada dropping the overnight rate to its effective lower bound of 0.25 per cent, and then on March 27, announcing its first foray into quantitative easing (large-scale asset purchases, in Bank of Canada parlance). These moves were successful in stabilizing financial markets, ensuring the lockdown did not turn into a simultaneous financial crisis.
As the economy reopened in May, a recovery of sorts began, with GDP increasing by 4.8 per cent in May and 6.5 per cent in June. However, the economy remains well below where it sat in February. In other words, we continue to have an economy running far below potential.
Despite this, the stock market has now caught up to where it was in the first week of March, before countrywide lockdowns began. This disconnect is concerning, especially because those invested in the stock market are many of the same folks who have kept their jobs during this economic downturn.
This raises alarm bells over the inequality of any economic recovery. The Governor of the Bank of Canada, himself, has noted that inequality is one of the biggest threats to a robust economic recovery.
The pattern of the stock market outpacing the real economy has been a phenomenon for much of the period between the last crisis, the Great Recession in 2007-09, and the current crisis. One reason for the high-paced growth in the stock market is low interest rates, which drive up asset prices, and make equity much more attractive than bonds.
This, no doubt, favours higher-income individuals who participate more in the stock market than those at the bottom of the income spectrum. The effect on inequality is exacerbated if the economy doesn’t grow alongside the stock market, leaving behind those who have lost their jobs.
Some are quick, then, to pin this low-interest-rate inequality issue on the central bank. But this is misguided. The Bank of Canada’s job is to hit the 2-per-cent inflation target, and it has very little in its arsenal to deal with income inequality issues that arise. Fiscal policy, on the other hand, has many more arrows in its quiver.
So, how should the Bank of Canada deal with income inequality? Put simply, it should focus on how its decisions vis-à-vis the overnight rate and asset purchases affect income inequality, and how income inequality feeds into its ability to hit the inflation target.
In a paper I co-authored this year with Francisco Villarreal at the UN Economic Commission for Latin America and the Caribbean, we investigated just this question. We found that expansionary monetary policy shocks – that is, when the bank’s overnight rate was set lower than expected – led to an increase in income inequality with more money going to higher-income earners, and the reverse was true under contractionary monetary policy.
To understand why, consider the two basic types of income a household receives: wages and capital income (think investment income). Expansionary monetary policy shocks result in a higher share of national income shifting to higher-income households (the capital owners), who consume less as a percentage of their income, dampening the increase in overall demand, and, therefore, inflation. The effect from contractionary monetary policy is the reverse.
Historically, a central banker might have looked at these results and said, "Yes, but over a business cycle, during which there is both expansionary and contractionary monetary policy, these effects net out.” However, this type of argument assumes the magnitudes of these effects are symmetric.
Alas, they are not.
The effect of expansionary monetary policy is greater in absolute terms. One potential explanation for this asymmetry is that contractionary monetary policy slows down economic growth simultaneously, negating any gain in income share experienced by those in lower income brackets.
While not as headline-grabbing as a central bank fighting income inequality, accounting for this asymmetry is vital for the Bank of Canada in forecasting economic behaviour, and as a result, for the Governing Council when undertaking its overnight rate decisions as they relate to hitting the inflation target.
Monetary policy that is too expansionary might, in part, explain why we have had trouble hitting the 2-per-cent target for much of the period after the financial crisis. And, therein lies the conundrum: When the central bank undershoots the target, the default response is to make monetary policy more expansionary. But if that exacerbates inequality, it may have the opposite effect on inflation.
Fiscal policy executed responsibly, in a way that increases the economic pie such that it puts money in the hands of people more likely to spend it, will stimulate aggregate demand at the right time. That time is now.
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