Past fiscal policy is still part of the current inflation problem

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How much of Canada’s nagging inflation problem can we blame on government spending?

The answer very much depends on how you ask the question.

In his interview with Bank of Canada Governor Tiff Macklem in the wake of the bank’s latest interest-rate increase, my colleague Mark Rendell asked if fiscal policy could be doing more to assist the central bank’s rate policy in tamping down inflation. Mr. Macklem interpreted the question as asking whether current levels of government spending are exacerbating the economy’s overheated demand – which is what the bank has been explicitly trying to cool via rising interest rates.

Mr. Macklem noted that in the bank’s latest economic projections, government spending growth is running at about two per cent – on par with the estimated rate that the economy’s potential output is growing. Which implies that the government’s contribution to the economy’s supply-demand balance is neutral; it’s not helping the excess demand problem that continues to fuel inflation pressures, but it’s not compounding the problem, either.

“Yes, I think it’s fair to say governments aren’t helping the disinflation process. But they’re not really in serious conflict with monetary policy, in the sense that they’re not the major factor that is making it more difficult to get inflation back to target,” Mr. Macklem said.

Fair enough. That’s one way of looking at whether governments’ spending footprint is leaning against the efforts of monetary policy.

But perhaps the better question is not whether governments are doing too much right now, but rather whether the too-much they did early in the COVID-19 pandemic now blocks the path to the central bank’s two-per-cent inflation target. From that perspective, fiscal policy is most certainly a continuing part of the problem.

The reality is that the fiscal footprint on the economy is considerably bigger today than it was before the pandemic. Even though Ottawa – by far the biggest source of pandemic stimulus – has wound up its emergency programs, spending has never dwindled back to pre-crisis levels. Federal program expenses will make up 16 per cent of gross domestic product this year, up from 14 per cent in 2019. Program spending among the three biggest provinces – Ontario, Quebec and British Columbia – is also higher, as a share of GDP, than it was pre-COVID.

That translates to a greater fiscal contribution to total demand in the economy. While it may be true that governments are no longer adding to the supply-demand gap, bigger government certainly helped create the excess demand in the first place.

What’s more, federal income supports contributed in a big way to the high level of savings that Canadian households accumulated during the pandemic. In its latest quarterly Monetary Policy Report, the Bank of Canada cited elevated household savings as among the key reasons why consumer spending has remained “surprisingly strong” in the face of the bank’s sharp increase of interest rates over the past 16 months. In short, savings that the government helped create, through past massive though temporary spending increases, are now interfering with the transmission of inflation-fighting monetary policy.

Then there’s Ottawa’s contribution to the persistently tight labour market, another factor that the MPR cited in the surprising resilience of household spending. Public-sector jobs make up only about 20 per cent of all employment in this country, but they have accounted for nearly half of all the jobs that the economy has added since the pandemic began – almost a half-million government jobs in total.

Federal public-service payrolls have swelled by nearly 25 per cent in the past four years. Ottawa expanded the public service more than six per cent in the 2022-2023 budget year alone.

So, it’s fair to say that fiscal policy absolutely continues to play a role in excess demand and inflation. And that there’s more that Ottawa could be doing to lean in the same direction as the central bank than it has done. Simply putting fiscal policy in neutral isn’t good enough.

Mind you, even if Mr. Macklem agrees with that assessment, it would be a tricky thing for him to come out and say so. The Bank of Canada does, after all, rely heavily on its status as an independent agency, free from political interference, to effectively and credibly manage the country’s monetary policy.

One consequence of protecting and defending that status is that the bank habitually steers clear of staking a public viewpoint on fiscal policy. It is, thus, standard practice for governors to dance around such questions.

Nevertheless, governments could and should be doing more to help the inflation fight – not just in Canada, but in many other countries where central banks have been waging most of the battle alone. Relying solely on steep increases of interest rates has proven insufficient, and has placed growing financial pressures on borrowers, creating a whole new set of risks as global rates have continued to rise.

“Some side effects of fighting inflation with monetary policy could be reduced by giving fiscal policy a bigger role. Indeed, economic conditions call for fiscal tightening,” economist Gita Gopinath, deputy executive director of the International Monetary Fund, argued in a speech to a European Central Bank conference last month.

“It could help cool demand and reduce the need for rising interest rates.”